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 TABLE OF CONTENTS

Page No.

Chapter 1 : SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT 1-21

1. Learning Outcomes 1

2. Chapter Overview 2

3. Summary 3

4. Practical Problems
A. Multiple Choice Questions 4

B. Illustration 6

C. Theoretical Questions 7

Chapter 2 : TYPES OF FINANCING 22-44

1. Learning Outcomes 22

2. Chapter Overview 23

3. Summary 24

4. Practical Problems
A. Multiple Choice Questions 25

B. Theoretical Questions 27

Chapter 3 : FINANCIAL ANALYSISANDPLANNING-RATIO ANALYSIS 45-118

1. Learning Outcomes 45

2. Chapter Overview 46

3. Example 47

4. Summary 48

5. Practical Problems
A. Multiple Choice Questions 49

B. Illustrations 50

C. Practice Questions 71

D. Other Problems 97

E. Theoretical Questions 111

Contd........
 Page No.

Chapter 4 : COST OF CAPITAL 119-180

1. Learning Outcomes 119

2. Chapter Overview 120

3. Examples 121

4. Summary 123

5. Practical Problems
A. Multiple Choice Questions 124

B. Illustrations 126

C. Practice Questions 136

D. Other Problems 172

E. Theoretical Questions 177

Chapter 5 : FINANCING DECISIONS - CAPITAL STRUCTURE 181-241

1. Learning Outcomes 181

2. Chapter Overview 182

3. Summary 183

4. Practical Problems
A. Multiple Choice Questions 184

B. Illustrations 186

C. Practice Questions 197

D. Other Problems 218

E. Theoretical Questions 233

Chapter 6 : FINANCING DECISIONS - LEVERAGES 242- 301

1. Learning Outcomes 242

2. Chapter Overview 243

3. Summary 244
4. Practical Problems
A. Multiple Choice Questions 245
B. Illustrations 247

C. Practice Questions 251

D. Other Problems 291
E. Theoretical Questions 298
 Page No.

Chapter 7 : INVESTMENT DECISIONS 302-411

1. Learning Outcomes 302

2. Chapter Overview 303

3. Summary 304

4. Practical Problems
A. Multiple Choice Questions 305

B. Illustrations 308

C. Practice Questions 332

D. Other Problems 395

E. Theoretical Questions 406

Chapter 8 : RISK ANALYSIS IN CAPITAL BUDGETING 412-437

1. Learning Outcomes 412

2. Chapter Overview 413

3. Summary 414

4. Practical Problems
A. Multiple Choice Questions 415

B. Illustrations 417

C. Practice Questions 432

D. Other Problems 435

E. Theoretical Questions 436

ICAI NOVEMBER 2018 QUESTION PAPER 438

 Chapter
SCOPE AND OBJECTIVES OF
1 FINANCIAL MANAGEMENT

LEARNING OUTCOMES
 State the meaning, importance and scope of financial management in an entity.
 Discuss Financing decisions/functions.
 Discuss the objectives of financial management; Profit maximisation vis-a-vis
Wealth maximisation.
 Discuss Shareholders’ value maximising approach.
 Examine the role and functions of Finance executives in an entity.
 Discuss Financial distress and insolvency.
 Discuss Agency cost and its mitigation.
 Discuss Agency problem and Agency cost.

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CHAPTER OVERVIEW

FINANCIAL MANAGEMENT

Scope and Objectives of Role and functions of Chief

Financial Management Finance Officer (CFO)

Profit Maximisation Relationship of

vis-s-vis Wealth Financial Management
Maximisation with other disciplines of
accounting

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SUMMARY

 Financial Management is concerned with efficient acquisition (financing) and

allocation (investment in assets, working capital etc) of funds.
 In the modern times, the financial management includes besides procurement of
funds, the three different kinds of decisions as well namely investment, financing
and dividend.
 Out of the two objectives, profit maximization and wealth maximization, in
today’s real world situations which is uncertain and multi-period in nature, wealth
maximization is a better objective.
 Today the role of chief financial officer, or CFO, is no longer confined to accounting,
financial reporting and risk management. It’s about being a strategic business
partner of the chief executive officer.
 The relationship between financial management and accounting are closely related
to the extent that accounting is an important input in financial decision making.
 Managers may work against the interest of the shareholders and try to fulfill their
own objectives. This is known as agency problem.

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. Management of all matters related to an organisation’s finances is called:

a. Cash inflows and outflows
b. Allocation of resources
c. Financial management
d. Finance.

2. Which of the following is not an element of financial management?

a. Allocation of resources
b. Financial Planning
c. Financial Decision-making
d. Financial control.

3. The most important goal of financial management is:

a. Profit maximisation
b. Matching income and expenditure
c. Using business assets effectively
d. Wealth maximisation.

4. To achieve wealth maximization, the finance manager has to take careful decision in
respect of:
a. Investment
b. Financing
c. Dividend
d. All the above.

5. Early in the history of finance, an important issue was:

a. Liquidity
b. Technology
c. Capital structure
d. Financing options.

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6. Which of the following are microeconomic variables that help define and explain the
discipline of finance?
a. Risk and return
b. Capital structure
c. Inflation
d. All of the above.

ANSWERS

1. c 2. d

3. d 4. d
5. a 6. d

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 ILLUSTRATION

Question 1.

Profit maximisation does not consider risk or uncertainty, whereas wealth maximization
considers both risk and uncertainty. Suppose there are two products, X and Y, and their
projected earnings over the next 5 years are as shown below:

Year Product X Product Y (`)

1 10,000 11,000
2 10,000 11,000
3 10,000 11,000
4 10,000 11,000
5 10,000 11,000
50,000 55,000
Source : ICAI SM (New)

Answer :

A profit maximisation approach would favour product Y over product X.

However, if product Y is more risky than product X, then the decision is not as
straightforward as the figures seem to indicate. It is important to realize that a trade-
off exists between risk and return. Stockholders expect greater returns from
investments of higher risk and vice-versa. To choose product Y, stockholders would
demand a sufficiently large return to compensate for the comparatively greater level
of risk.

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 THEORETICAL QUESTIONS

Source : ICAI, PM (Old) - (From Question No. 1 - 12 )

Question 1

Explain two basic functions of Financial Management.

Answer :

Two Basic Functions of Financial Management

Procurement of Funds: Funds can be obtained from different sources having
different characteristics in terms of risk, cost and control. The funds raised from the issue of
equity shares are the best from the risk point of view since repayment is required only at
the time of liquidation. However, it is also the most costly source of finance due to
dividend expectations of shareholders. On the other hand, debentures are cheaper than
equity shares due to their tax advantage. However, they are usually riskier than equity
shares. There are thus risk, cost and control considerations which a finance manager must
consider while procuring funds. The cost of funds should be at the minimum level for that
a proper balancing of risk and control factors must be carried out.

Effective Utilization of Funds: The Finance Manager has to ensure that funds are not kept
idle or there is no improper use of funds. The funds are to be invested in a manner such
that they generate returns higher than the cost of capital to the firm. Besides this, decisions
to invest in fixed assets are to be taken only after sound analysis using capital budgeting
techniques. Similarly, adequate working capital should be maintained so as to avoid the
risk of insolvency.

Question 2

Differentiate between Financial Management and Financial Accounting.

Answer :

Differentiation between Financial Management and Financial Accounting: Though

financial management and financial accounting are closely related, still they differ in
the treatment of funds and also with regards to decision - making.

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Treatment of Funds: In accounting, the measurement of funds is based on the accrual

principle. The accrual based accounting data do not reflect fully the financial conditions of
the organisation. An organisation which has earned profit (sales less expenses) may said
to be profitable in the accounting sense but it may not be able to meet its current obligations
due to shortage of liquidity as a result of say, uncollectible receivables. Whereas, the
treatment of funds, in financial management is based on cash flows. The revenues are
recognised only when cash is actually received (i.e. cash inflow) and expenses are
recognised on actual payment (i.e. cash outflow). Thus, cash flow based returns help
financial managers to avoid insolvency and achieve desired financial goals.

Decision-making: The chief focus of an accountant is to collect data and present the data
while the financial manager’s primary responsibility relates to financial planning,
controlling and decision- making. Thus, in a way it can be stated that financial management
begins where financial accounting ends.

Question 3

Explain the limitations of profit maximization objective of Financial Management.

Answer :

Limitations of Profit Maximisation objective of financial management.

a. Time factor is ignored.
b. It is vague because it is not cleared whether the term relates to economics profit,
accounting profit, profit after tax or before tax.
c. The term maximisation is also ambiguous
d. It ignore, the risk factor.

Question 4

Discuss the conflicts in Profit versus Wealth maximization principle of the firm.

Answer :

Conflict in Profit versus Wealth Maximization Principle of the Firm: Profit maximisation
is a short-term objective and cannot be the sole objective of a company. It is at best a
limited objective. If profit is given undue importance, a number of problems can arise like
the term profit is vague, profit maximisation has to be attempted with a realisation of risks
involved, it does not take into account the time pattern of returns and as an objective it is
too narrow.

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Whereas, on the other hand, wealth maximisation, as an objective, means that the company
is using its resources in a good manner. If the share value is to stay high, the company has
to reduce its costs and use the resources properly. If the company follows the goal of wealth
maximisation, it means that the company will promote only those policies that will lead to
an efficient allocation of resources.

Question 5

Explain as to how the wealth maximisation objective is superior to the profit

maximisation objective.

Answer :

A firm’s financial management may often have the following as their objectives:
i. The maximisation of firm’s profit.
ii. The maximisation of firm’s value / wealth.
The maximisation of profit is often considered as an implied objective of a firm. To achieve
the aforesaid objective various type of financing decisions may be taken. Options
resulting into maximisation of profit may be selected by the firm’s decision makers. They
even sometime may adopt policies yielding exorbitant profits in short run which may
prove to be unhealthy for the growth, survival and overall interests of the firm. The profit
of the firm in this case is measured in terms of its total accounting profit available to its
shareholders.

The value/wealth of a firm is defined as the market price of the firm’s stock. The market
price of a firm’s stock represents the focal judgment of all market participants as to what
the value of the particular firm is. It takes into account present and prospective future
earnings per share, the timing and risk of these earnings, the dividend policy of the firm
and many other factors that bear upon the market price of the stock.

The value maximisation objective of a firm is superior to its profit maximisation objective
due to following reasons.
1. The value maximisation objective of a firm considers all future cash flows,
dividends, earning per share, risk of a decision etc. whereas profit maximisation
objective does not consider the effect of EPS, dividend paid or any other returns to
shareholders or the wealth of the shareholder.

2. A firm that wishes to maximise the shareholders wealth may pay regular dividends
whereas a firm with the objective of profit maximisation may refrain from dividend
payment to its shareholders.

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 SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

3. Shareholders would prefer an increase in the firm’s wealth against its generation
of increasing flow of profits.

4. The market price of a share reflects the shareholders expected return, considering
the long-term prospects of the firm, reflects the differences in timings of the returns,
considers risk and recognizes the importance of distribution of returns.

The maximisation of a firm’s value as reflected in the market price of a share is viewed as a
proper goal of a firm. The profit maximisation can be considered as a part of the
wealth maximisation strategy.

Question 6

“The profit maximization is not an operationally feasible criterion.” Comment on it.

Answer :

“The profit maximisation is not an operationally feasible criterion.” This statement is

true because Profit maximisation can be a short-term objective for any organisation and
cannot be its sole objective. Profit maximization fails to serve as an operational criterion for
maximizing the owner's economic welfare. It fails to provide an operationally feasible
measure for ranking alternative courses of action in terms of their economic efficiency. It
suffers from the following limitations:
i. Vague term: The definition of the term profit is ambiguous. Does it mean short term or
long term profit? Does it refer to profit before or after tax? Total profit or profit per
share?
ii. Timing of Return: The profit maximization objective does not make distinction
between returns received in different time periods. It gives no consideration to the
time value of money, and values benefits received today and benefits received
after a period as the same.
iii. It ignores the risk factor.
iv. The term maximization is also vague.

Question 7

“The information age has given a fresh perspective on the role of finance management
and finance managers. With the shift in paradigm it is imperative that the role of Chief
Financial Officer (CFO) changes from a controller to a facilitator.” Can you describe the
emergent role which is described by the speaker/author?

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Answer :

The information age has given a fresh perspective on the role financial management and
finance managers. With the shift in paradigm it is imperative that the role of Chief Finance
Officer (CFO) changes from a controller to a facilitator. In the emergent role Chief Finance
Officer acts as a catalyst to facilitate changes in an environment where the organisation
succeeds through self managed teams. The Chief Finance Officer must transform himself to
a front-end organiser and leader who spends more time in networking, analysing the
external environment, making strategic decisions, managing and protecting cash flows.
In due course, the role of Chief Finance Officer will shift from an operational to a
strategic level. Of course on an operational level the Chief Finance Officer cannot be
excused from his backend duties. The knowledge requirements for the evolution of a
Chief Finance Officer will extend from being aware about capital productivity and cost of
capital to human resources initiatives and competitive environment analysis. He has
to develop general management skills for a wider focus encompassing all aspects of
business that depend on or dictate finance.

Question 8

Discuss the functions of a Chief Financial Officer.

Answer :

Functions of a Chief Financial Officer: The twin aspects viz procurement and effective
utilization of funds are the crucial tasks, which the CFO faces. The Chief Finance Officer is
required to look into financial implications of any decision in the firm. Thus all decisions
involving management of funds comes under the purview of finance manager. These are
namely
 Estimating requirement of funds
 Decision regarding capital structure
 Investment decisions
 Dividend decision
 Cash management
 Evaluating financial performance
 Financial negotiation
 Keeping touch with stock exchange quotations & behaviour of share prices.

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Question 9

Write short notes on the following:

a. Inter relationship between investment, financing and dividend decisions.
b. Finance function

Answer :

a. Inter-relationship between Investment, Financing and Dividend Decisions: The

finance functions are divided into three major decisions, viz., investment, financing
and dividend decisions. It is correct to say that these decisions are inter-related because
the underlying objective of these three decisions is the same, i.e. maximisation of
shareholders’ wealth. Since investment, financing and dividend decisions are all
interrelated, one has to consider the joint impact of these decisions on the market price
of the company’s shares and these decisions should also be solved jointly. The decision
to invest in a new project needs the finance for the investment. The financing
decision, in turn, is influenced by and influences dividend decision because retained
earnings used in internal financing deprive shareholders of their dividends. An
efficient financial management can ensure optimal joint decisions. This is possible
by evaluating each decision in relation to its effect on the shareholders’ wealth.

The above three decisions are briefly examined below in the light of their inter-
relationship and to see how they can help in maximising the shareholders’ wealth i.e.
market price of the company’s shares.

Investment decision: The investment of long term funds is made after a careful
assessment of the various projects through capital budgeting and uncertainty analysis.
However, only that investment proposal is to be accepted which is expected to yield
at least so much return as is adequate to meet its cost of financing. This have an
influence on the profitability of the company and ultimately on its wealth.

Financing decision: Funds can be raised from various sources. Each source of
funds involves different issues. The finance manager has to maintain a proper balance
between long-term and short-term funds. With the total volume of long-term funds, he
has to ensure a proper mix of loan funds and owner’s funds. The optimum financing
mix will increase return to equity shareholders and thus maximise their wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or
declare dividend. He assists the top management in deciding as to what portion of the
profit should be paid to the shareholders by way of dividends and what portion should

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be retained in the business. An optimal dividend pay-out ratio maximises shareholders’

wealth.

The above discussion makes it clear that investment, financing and dividend decisions
are interrelated and are to be taken jointly keeping in view their joint effect on the
shareholders’ wealth.

b. Finance Function: The finance function is most important for all business enterprises. It
remains a focus of all activities. It starts with the setting up of an enterprise. It is
concerned with raising of funds, deciding the cheapest source of finance, utilization of
funds raised, making provision for refund when money is not required in the business,
deciding the most profitable investment, managing the funds raised and paying returns
to the providers of funds in proportion to the risks undertaken by them. Therefore,
it aims at acquiring sufficient funds, utilizing them properly, increasing the profitability
of the organization and maximizing the value of the organization and ultimately the
shareholder’s wealth.

Question 10

Explain the role of Finance Manager in the changing scenario of financial management
in India.

Answer :

Role of Finance Manager in the Changing Scenario of Financial Management in India: In

the modern enterprise, the finance manager occupies a key position and his role is
becoming more and more pervasive and significant in solving the finance problems. The
traditional role of the finance manager was confined just to raising of funds from a number
of sources, but the recent development in the socio-economic and political scenario
throughout the world has placed him in a central position in the business organisation. He
is now responsible for shaping the fortunes of the enterprise, and is involved in the most
vital decision of allocation of capital like mergers, acquisitions, etc. He is working in a
challenging environment which changes continuously.

Emergence of financial service sector and development of internet in the field of

information technology has also brought new challenges before the Indian finance
managers. Development of new financial tools, techniques, instruments and products and
emphasis on public sector undertaking to be self-supporting and their dependence on
capital market for fund requirements have all changed the role of a finance manager. His

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role, especially, assumes significance in the present day context of liberalization,

deregulation and globalization.

Question 11

What are the main responsibilities of a Chief Financial Officer of an organisation?

Answer :

Responsibilities of Chief Financial Officer (CFO): The chief financial officer of an

organisation plays an important role in the company’s goals, policies, and financial
success. His main responsibilities include:
a. Financial analysis and planning: Determining the proper amount of funds to be
employed in the firm.
b. Investment decisions: Efficient allocation of funds to specific assets.
c. Financial and capital structure decisions: Raising of funds on favourable terms as
possible, i.e., determining the composition of liabilities.
d. Management of financial resources (such as working capital).
e. Risk Management: Protecting assets.

Question 12

Discuss emerging issues affecting the future role of Chief Financial Officer (CFO).

Answer :

Emerging Issues/Priorities Affecting the Future Role of Chief Financial Officer (CFO)
i. Regulation: Regulation requirements are increasing and CFOs have an increasingly
personal stake in regulatory adherence.

ii. Globalisation: The challenges of globalisation are creating a need for finance
leaders to develop a finance function that works effectively on the global stage
and that embraces diversity.

iii. Technology: Technology is evolving very quickly, providing the potential for
CFOs to reconfigure finance processes and drive business insight through ‘big data’
and analytics.

iv. Risk: The nature of the risks that organisations face is changing, requiring more
effective risk management approaches and increasingly CFOs have a role to play
in ensuring an appropriate corporate ethos.

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v. Transformation: There will be more pressure on CFOs to transform their finance

functions to drive a better service to the business at zero cost impact.

vi. Stakeholder Management: Stakeholder management and relationships will become

important as increasingly CFOs become the face of the corporate brand.

vii. Strategy: There will be a greater role to play in strategy validation and execution,
because the environment is more complex and quick changing, calling on the
analytical skills CFOs can bring.

viii. Reporting: Reporting requirements will broaden and continue to be burdensome for
CFOs.

ix. Talent and Capability: A brighter spotlight will shine on talent, capability and
behaviours in the top finance role.

Question 13

State Agency Cost. Discuss the ways to reduce the effect of it.
Source : ICAI, MTP- I (New)
Answer :

Agency Cost : In a sole proprietorship firm, partnership etc., owners participate in

management but in corporate, owners are not active in management so, there is a
separation between owner/ shareholders and managers. In theory managers should act in
the best interest of shareholders however in reality, managers may try to maximise their
individual goal like salary, perks etc., so there is a principal-agent relationship between
managers and owners, which is known as Agency Problem. In a nutshell, Agency Problem
is the chances that managers may place personal goals ahead of the goal of owners. Agency
Problem leads to Agency Cost. Agency cost is the additional cost borne by the shareholders
to monitor the manager and control their behaviour so as to maximise shareholders
wealth. Generally, Agency Costs are of four types (i) monitoring (ii) bonding (iii)
opportunity (iv) structuring

However, following efforts can be made to address Agency Cost:

Managerial compensation to be linked to profit of the company to some extent with the
long term objectives of the company.

Employees’ Stock option plan (ESOP) is also designed to address the issue with the
underlying assumption that maximisation of the stock price is the objective of the investors.

Effective monitoring through corporate governance can be done.

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Question 14

Discuss the three major decisions taken by a finance manager to maximize the wealth
of shareholders.
Source : ICAI, MTP- II (New)
Answer :

To achieve wealth maximization, a finance manager has to take careful decision in

respect of:
i. Investment decisions : These decisions relate to the selection of assets in which funds
will be invested by a firm. Funds procured from different sources have to be invested in
various kinds of assets. Long term funds are used in a project for various fixed assets
and also for current assets. The investment of funds in a project has to be made after
careful assessment of the various projects through capital budgeting. A part of long
term funds is also to be kept for financing the working capital requirements. Asset
management policies are to be laid down regarding various items of current assets. The
inventory policy would be determined by the production manager and the finance
manager keeping in view the requirement of production and the future price estimates
of raw materials and the availability of funds.

ii. Financing decisions : These decisions relate to acquiring the optimum finance to
meet financial objectives and seeing that fixed and working capital are effectively
managed. The financial manager needs to possess a good knowledge of the sources of
available funds and their respective costs and needs to ensure that the company has a
sound capital structure, i.e. a proper balance between equity capital and debt.
Financing decisions also call for a good knowledge of evaluation of risk, e.g.
excessive debt carried high risk for an organization’s equity because of the priority
rights of the lenders.

iii. Dividend decisions : These decisions relate to the determination as to how much and
how frequently cash can be paid out of the profits of an organisation as income for its
owners/shareholders. The dividend decision thus has two elements – the amount to be
paid out and the amount to be retained to support the growth of the organisation, the
latter being also a financing decision; the level and regular growth of dividends
represent a significant factor in determining a profit-making company’s market value,
i.e. the value placed on its shares by the stock market.

All three types of decisions are interrelated, the first two pertaining to any kind of
organisation while the third relates only to profit-making organisations, thus it can be

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seen that financial management is of vital importance at every level of business activity,
from a sole trader to the largest multinational corporation.

Question 15

What are the roles of Finance Executive in Modern World?

OR
What are the two main aspects of the Finance Function?
Source : ICAI, May 2018 Question Paper
Answer :

Role of Finance Executive in modern World

Today, the role of Financial Executive, is no longer confined to accounting, financial
reporting and risk management. Some of the key activities that highlight the
changing role of a Finance Executive are as follows:-
 Budgeting
 Forecasting
 Managing M & As
 Profitability analysis relating to customers or products
 Pricing Analysis
 Decisions about outsourcing
 Overseeing the IT function.
 Overseeing the HR function.
 Strategic planning (sometimes overseeing this function).
 Regulatory compliance.
 Risk management.
OR
Value of a firm will depend on various finance functions/decisions. It can be
expressed as:

V = f (I,F,D).

The finance functions are divided into long term and short term functions/decisions

Long term Finance Function Decisions

a. Investment decisions (I) : These decisions relate to the selection of assets in which
funds will be invested by a firm. Funds procured from different sources have to be
invested in various kinds of assets. Long term funds are used in a project for
various fixed assets and also for current assets.

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b. Financing decisions (F) : These decisions relate to acquiring the optimum finance to
meet financial objectives and seeing that fixed and working capital are effectively
managed.
c. Dividend decisions(D) : These decisions relate to the determination as to how
much and how frequently cash can be paid out of the profits of an organisation as
income for its owners/shareholders. The owner of any profit-making organization
looks for reward for his investment in two ways, the growth of the capital invested and
the cash paid out as income; for a sole trader this income would be termed as drawings
and for a limited liability company the term is dividends.

Short- term Finance Decisions/Function

Working capital Management (WCM) : Generally short term decision are reduced
to management of current asset and current liability (i.e., working capital Management)

Question 16

“Financial Managers should concentrate on meeting the needs of shareholders by

maximising earnings per share – no other stakeholders matter.” Do you agree with this
statement?
Source : ICAI, RTP November 2013 (Old)
Answer :

Financial managers are concerned with managing the company’s funds on behalf of the
shareholders, and producing information which reflects the effect of management decisions
on shareholders wealth. However, management decisions will be made only after
considering other stakeholders also and a good financial manager will be aware that
financial information is only one input to the final decision.

Question 17

Write a short note on “Inter-relationship between Investment, Financing and Dividend

Decisions”.
Source : ICAI, RTP May 2015 (Old)
Answer :

Inter-relationship between Investment, Financing and Dividend Decisions : The finance

functions are divided into three major decisions, viz., investment, financing and dividend
decisions. These decisions are inter-related because the underlying objective of these
three decisions is the same, i.e. maximisation of shareholders’ wealth. Since
investment, financing and dividend decisions are all interrelated, one has to consider the

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joint impact of these decisions on the market price of the company’s shares and these
decisions should also be solved jointly. The decision to invest in a new project needs the
finance for the investment. The financing decision, in turn, is influenced by and influences
dividend decision because retained earnings used in internal financing deprive
shareholders of their dividends. An efficient financial management can ensure optimal
joint decisions. This is possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.

The above three decisions are briefly examined below in the light of their inter-
relationship and to see how they can help in maximising the shareholders’ wealth
i.e. market price of the company’s shares.

Investment decision : The investment of long term funds is made after a careful
assessment of the various projects through capital budgeting and uncertainty analysis.
However, only that investment proposal is to be accepted which is expected to yield
at least so much return as is adequate to meet its cost of financing. This has an
influence on the profitability of the company and ultimately on its wealth.

Financing decision : Funds can be raised from various sources. Each source of funds
involves different issues. The finance manager has to maintain a proper balance
between long-term and short-term funds. With the total volume of long-term funds, he has
to ensure a proper mix of loan funds and owner’s funds. The optimum financing mix will
increase return to equity shareholders and thus maximise their wealth.

Dividend decision : The finance manager is also concerned with the decision to pay or
declare dividend. He assists the top management in deciding as to what portion of the
profit should be paid to the shareholders by way of dividends and what portion
should be retained in the business. An optimal dividend pay-out ratio maximises
shareholders’ wealth.

The above discussion makes it clear that investment, financing and dividend
decisions are interrelated and are to be taken jointly keeping in view their joint effect on the
shareholders’ wealth.

Question 18

“The profit maximization is not an operationally feasible criterion.”Comment on it.

Source : ICAI, RTP November 2015 (Old)

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 SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

Answer :

“The profit maximisation is not an operationally feasible criterion.”This statement is true

because Profit maximisation can be a short-term objective for any organisation and cannot
be its sole objective. Profit maximization fails to serve as an operational criterion for
maximizing the owner's economic welfare. It fails to provide an operationally feasible
measure for ranking alternative courses of action in terms of their economic efficiency. It
suffers from the following limitations:

i. Vague term : The definition of the term profit is ambiguous. Does it mean short term or
long term profit? Does it refer to profit before or after tax? Total profit or profit per
share?

ii. Timing of Return : The profit maximization objective does not make distinction
between returns received in different time periods. It gives no consideration to the time
value of money, and values benefits received today and benefits received after a
period as the same.

iii. It ignores the risk factor.

iv. The term maximization is also vague

Question 19

Write short notes on Functions of Finance Manager.

Source : ICAI, RTP May 2016 (Old)
Answer :

Functions of Finance Manager

The Finance Manager’s main objective is to manage funds in such a way so as to ensure
their optimum utilisation and their procurement in a manner that the risk, cost and
control considerations are properly balanced in a given situation. To achieve these
objectives the Finance Manager performs the following functions:

i. Estimating the requirement of Funds : Both for long-term purposes i.e. investment
in fixed assets and for short-term i.e. for working capital. Forecasting the
requirements of funds involves the use of techniques of budgetary control and
long-range planning.

ii. Decision regarding Capital Structure : Once the requirement of funds has been
estimated, a decision regarding various sources from which these funds would be raised
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has to be taken. A proper balance has to be made between the loan funds and own
funds. He has to ensure that he raises sufficient long term funds to finance fixed
assets and other long term investments and to provide for the needs of working
capital.

iii. Investment Decision : The investment of funds, in a project has to be made after
careful assessment of various projects through capital budgeting. Assets management
policies are to be laid down regarding various items of current assets. For e.g.
receivable in coordination with sales manager, inventory in coordination with
production manager.

iv. Dividend decision : The finance manager is concerned with the decision as to how
much to retain and what portion to pay as dividend depending on the company’s
policy. Trend of earnings, trend of share market prices, requirement of funds for future
growth, cash flow situation etc., are to be considered.

v. Evaluating financial performance : A finance manager has to constantly review the

financial performance of the various units of organisation generally in terms of
ROI Such a review helps the management in seeing how the funds have been utilised in
various divisions and what can be done to improve it.

vi. Financial negotiation : The finance manager plays a very important role in carrying
out negotiations with the financial institutions, banks and public depositors for raising
of funds on favourable terms.

[Link] management : The finance manager lays down the cash management and cash
disbursement policies with a view to supply adequate funds to all units of organisation
and to ensure that there is no excessive cash.

[Link] touch with stock exchange : Finance manager is required to analyse major
trends in stock market and their impact on the price of the company share.

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Chapter
TYPES OF FINANCING
2

LEARNING OUTCOMES
 Describe different sources of finance available to a business, both internal and
external.
 Discuss various long term, medium term and short term sources of finance.
 Discuss in detail some of the important sources of finance, this would include
Venture Capital financing, Lease financing and financing of export trade by banks.
 Discuss the concept of Securitisation
 Discuss the financing in the International market by understanding various financial
instruments prevalent in the international market.

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CHAPTER OVERVIEW

SOURCES OF FINANCE

Loan from
Financial Debentures Retained Preference Equity Share
Others
Institutions /Bond Earnings Share Capital Capital

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SUMMARY

 There are several sources of finance/funds available to any company.

 All the financial needs of a business may be grouped into the long term or short term
financial needs.
 There are different sources of funds available to meet long term financial needs of
the business. These sources may be broadly classified into share capital (both equity
and preference) and debt.
 Another important source of long term finance is venture capital financing. it
refers to financing of new high risky venture promoted by qualified entrepreneurs
who lack experience and funds to give shape to their ideas.
 Securitisation is another important source of finance and it is a process in which
illiquid assets are pooled into marketable securities that can be sold to investors.
 Leasing is a very popular source to finance equipment. it is acon tract between the
owner and user of the asset over a specified period of time in which the asset is
purchased initially by the lessor (leasing company) and thereafter leased to the user
(lessee company) who pays a specified rent at periodical intervals.
 Some of the short terms sources of funding are trade credit, advances from
customers, commercial paper, and bank advances etc.
 To support export, the commercial banks provide short term export finance mainly
by way of pre and post-shipment credit.
 Every day new creative financial products keep on entering the market. some of the
examples are seed capital assistance, deep discount bonds, option bonds,
inflation bonds etc.
 Today the businesses are allowed to source funds from international market also.
some of important products are External Commercial Borrowings(ECB), Euro
Bonds, American Depository Receipts (ADR) etc.

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. Equity shares :
a. Have an unlimited life, and voting rights and receive dividends
b. Have a limited life, with no voting rights but receive dividends
c. Have a limited life, and voting rights and receive dividends
d. Have an unlimited life, and voting rights but receive no dividends

2. External sources of finance do not include:

a. Debentures
b. Retained earnings
c. Overdrafts
d. Leasing

3. Internal sources of finance do not include:

a. Better management of working capital
b. Ordinary shares
c. Retained earnings
d. Trade credit

4. Preference shares:
a. Do not get dividends
b. Have no voting rights
c. Are not part of a company’s share capital
d. Receive dividends

5. A debenture:
a. Is a long-term loan
b. Does not require security
c. Is a short-term loan
d. Receives dividend payments

6. Debt capital refers to:

a. Money raised through the sale of shares.
b. Funds raised by borrowing that must be repaid.
c. Factoring accounts receivable.
d. Inventory loans.

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7. The most popular source of short-term funding is:

a. Factoring.
b. Trade credit.
c. Family and friends.
d. Commercial banks.

ANSWERS

1. a 2. b
3. b 4. b
5. a 6. b
7. b

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 THEORETICAL QUESTIONS

Source : ICAI, PM (Old) - (From Question No. 1 - 23 )

Question 1

Explain the importance of trade credit and accruals as source of working capital. What is
the cost of these sources?

Answer :

Trade credit and accruals as source of working capital refers to credit facility given by
suppliers of goods during the normal course of trade. It is a short term source of finance.
SSI firms in particular are heavily dependent on this source for financing their working
capital needs. The major advantages of trade credit are − easy availability, flexibility and
informality.

There can be an argument that trade credit is a cost free source of finance. But it is not. It
involves implicit cost. The supplier extending trade credit incurs cost in the form of
opportunity cost of funds invested in trade receivables. Generally, the supplier passes
on these costs to the buyer by increasing the price of the goods or alternatively by not
extending cash discount facility.

Question 2

What is debt securitisation? Explain the basics of debt securitisation process.

Answer :

Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to

financial intermediaries to support the lending volumes. Assets generating steady
cash flows are packaged together and against this asset pool, market securities can be
issued, e.g. housing finance, auto loans, and credit card receivables.

Process of Debt Securitisation

i. The origination function – A borrower seeks a loan from a finance company, bank,
HDFC. The credit worthiness of borrower is evaluated and contract is entered into with
repayment schedule structured over the life of the loan.

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ii. The pooling function – Similar loans on receivables are clubbed together to
create an underlying pool of assets. The pool is transferred in favour of Special
purpose Vehicle (SPV), which acts as a trustee for investors.

iii. The securitisation function – SPV will structure and issue securities on the basis of
asset pool. The securities carry a coupon and expected maturity which can be asset-
based/mortgage based. These are generally sold to investors through merchant
bankers. Investors are – pension funds, mutual funds, insurance funds.

The process of securitization is generally without recourse i.e. investors bear the credit risk
and issuer is under an obligation to pay to investors only if the cash flows are received by
him from the collateral. The benefits to the originator are that assets are shifted off the
balance sheet, thus giving the originator recourse to off-balance sheet funding.

Question 3

Discuss the risk-return considerations in financing of current assets.

Answer :

The financing of current assets involves a trade off between risk and return. A firm can
choose from short or long term sources of finance. Short term financing is less expensive
than long term financing but at the same time, short term financing involves greater
risk than long term financing.

Depending on the mix of short term and long term financing, the approach followed
by a company may be referred as matching approach, conservative approach and
aggressive approach.

In matching approach, long-term finance is used to finance fixed assets and

permanent current assets and short term financing to finance temporary or variable
current assets. Under the conservative plan, the firm finances its permanent assets and
also a part of temporary current assets with long term financing and hence less risk of
facing the problem of shortage of funds.

An aggressive policy is said to be followed by the firm when it uses more short term
financing than warranted by the matching plan and finances a part of its permanent current
assets with short term financing.

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Question 4

Discuss the eligibility criteria for issue of commercial paper.

Answer :

Eligibility criteria for issuer of commercial paper

The companies satisfying the following conditions are eligible to issue commercial paper.
 The tangible net worth of the company is ` 5 crores or more as per audited balance sheet
of the company.
 The fund base working capital limit is not less than ` 5 crores.
 The company is required to obtain the necessary credit rating from the rating
agencies such as CRISIL, ICRA etc.
 The issuers should ensure that the credit rating at the time of applying to RBI should not
be more than two months old.
 The minimum current ratio should be 1.33:1 based on classification of current assets and
liabilities.
 For public sector companies there are no listing requirement but for companies other
than public sector, the same should be listed on one or more stock exchanges.
 All issue expenses shall be borne by the company issuing commercial paper.

Question 5

Write short notes on the following:

a. Global Depository Receipts or Euro Convertible Bonds.
b. American Depository Receipts (ADRs)
c. Bridge Finance
d. Methods of Venture Capital Financing
e. Advantages of Debt Securitisation
f. Deep Discount Bonds vs. Zero Coupon Bonds
g. Venture capital financing
h. Seed capital assistance
i. Global Depository Receipts vs. American Depository Receipts.
j. Floating Rate Bonds
k. Packing Credit

Answer :

a. Global Depository Receipts (GDRs): It is a negotiable certificate denominated in

US dollars which represents a Non-US company’s publically traded local currency

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equity shares. GDRs are created when the local currency shares of an Indian
company are delivered to Depository’s local custodian Bank against which the
Depository bank issues depository receipts in US dollars. The GDRs may be traded
freely in the overseas market like any other dollar-expressed security either on a foreign
stock exchange or in the over- the-counter market or among qualified institutional
buyers.
By issue of GDRs Indian companies are able to tap global equity market to raise foreign
currency funds by way of equity. It has distinct advantage over debt as there is
no repayment of the principal and service costs are lower.
OR
Euro Convertible Bond: Euro Convertible bonds are quasi-debt securities (unsecured)
which can be converted into depository receipts or local shares. ECBs offer the investor
an option to convert the bond into equity at a fixed price after the minimum lock in
period. The price of equity shares at the time of conversion will have a premium
element. The bonds carry a fixed rate of interest. These are bearer securities and
generally the issue of such bonds may carry two options viz. call option and put option.
A call option allows the company to force conversion if the market price of the shares
exceeds a particular percentage of the conversion price. A put option allows the
investors to get his money back before maturity. In the case of ECBs, the payment of
interest and the redemption of the bonds will be made by the issuer company in US
dollars. ECBs issues are listed at London or Luxemburg stock exchanges.

An issuing company desirous of raising the ECBs is required to obtain prior permission
of the Department of Economic Affairs, Ministry of Finance, Government of India,
Companies having 3 years of good track record will only be permitted to raise funds.
The condition is not applicable in the case of projects in infrastructure sector. The
proceeds of ECBs would be permitted only for following purposes:
i. Import of capital goods
ii. Retiring foreign currency debts
iii. Capitalising Indian joint venture abroad
iv. 25% of total proceedings can be used for working capital and general corporate
restructuring.
The impact of such issues has been to procure for the issuing companies’ finances at
very competitive rates of interest. For the country a higher debt means a forex outgo in
terms of interest.

b. American Depository Receipts (ADRs) : American Depository Receipts (ADRs) are

securities offered by non- US companies who want to list on any of the US exchanges. It
is a derivative instrument. It represents a certain number of company’s shares. These are
used by depository bank against a fee income. ADRs allow US investors to buy shares of
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these companies without the cost of investing directly in a foreign stock exchange.
ADRs are listed on either NYSE or NASDAQ. It facilitates integration of global capital
markets. The company can use the ADR route either to get international listing or to
raise money in international capital market.

c. Bridge Finance: Bridge finance refers, normally, to loans taken by the business, usually
from commercial banks for a short period, pending disbursement of term loans by
financial institutions, normally it takes time for the financial institution to finalise
procedures of creation of security, tie-up participation with other institutions etc. even
though a positive appraisal of the project has been made. However, once the loans are
approved in principle, firms in order not to lose further time in starting their projects
arrange for bridge finance. Such temporary loan is normally repaid out of the proceeds
of the principal term loans. It is secured by hypothecation of moveable assets, personal
guarantees and demand promissory notes. Generally rate of interest on bridge finance
is higher as compared with that on term loans.

d. Methods of Venture Capital Financing: The venture capital financing refers to

financing and funding of the small scale enterprises, high technology and risky
ventures. Some common methods of venture capital financing are as follows:
i. Equity financing: The venture capital undertakings generally requires funds
for a longer period but may not be able to provide returns to the investors during
the initial stages. Therefore, the venture capital finance is generally provided by way
of equity share capital. The equity contribution of venture capital firm does not
exceed 49% of the total equity capital of venture capital undertakings so that the
effective control and ownership remains with the entrepreneur.

ii. Conditional Loan: A conditional loan is repayable in the form of a royalty after
the venture is able to generate sales. No interest is paid on such loans. In India
Venture Capital Financers charge royalty ranging between 2 to 15 per cent;
actual rate depends on other factors of the venture such as gestation period, cash
flow patterns, riskiness and other factors of the enterprise. Some Venture Capital
financers give a choice to the enterprise of paying a high rate of interest (which could
be well above 20 per cent) instead of royalty on sales once it becomes commercially
sound.

iii. Income Note: It is a hybrid security which combines the features of both
conventional loan and conditional loan. The entrepreneur has to pay both interest
and royalty on sales but at substantially low rates. IDBI’s Venture Capital Fund
provides funding equal to 80-87.5% of the project’s cost for commercial application
of indigenous technology or adopting imported technology to domestic applications.

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iv. Participating Debenture: Such security carries charges in three phases- in the start-
up phase, no interest is charged, next stage a low rate of interest is charged upto a
particular level of operations, after that, a high rate of interest is required to be paid.

e. Advantages of Debt Securitisation: Debt securitisation is a method of recycling of

funds and is especially beneficial to financial intermediaries to support lending
volumes. Simply stated, under debt securitisation a group of illiquid assets say a
mortgage or any asset that yields stable and regular cash flows like bank loans,
consumer finance, and credit card payment are pooled together and sold to
intermediary. The intermediary then issue debt securities.
The advantages of debt securitisation to the originator are the following:
i. The asset is shifted off the Balance Sheet, thus giving the originator recourse to off
balance sheet funding.
ii. It converts illiquid assets to liquid portfolio.
iii. It facilitates better balance sheet management; assets are transferred off balance
sheet facilitating satisfaction of capital adequacy norms.
iv. The originator’s credit rating enhances.
For the investors securitisation opens up new investment avenues. Though the investor
bears the credit risk, the securities are tied up to definite assets.

f. Deep Discount Bonds vs. Zero Coupon Bonds: Deep Discount Bonds (DDBs) are in the
form of zero interest bonds. These bonds are sold at a discounted value and on maturity
face value is paid to the investors. In such bonds, there is no interest payout during
lock- in period.

IDBI was first to issue a Deep Discount Bonds (DDBs) in India in January 1992. The
bond of a face value of ` 1 lakh was sold for ` 2,700 with a maturity period of 25 years.

A zero coupon bond (ZCB) does not carry any interest but it is sold by the issuing
company at a discount. The difference between discounted value and maturing or
face value represents the interest to be earned by the investor on such bonds.

g. Venture Capital Financing: The term venture capital refers to capital investment made
in a business or industrial enterprise, which carries elements of risks and insecurity and
the probability of business hazards. Capital investment may assume the form of
either equity or debt or both as a derivative instrument. The risk associated with the
enterprise could be so high as to entail total loss or be so insignificant as to lead to high
gains.

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The European Venture Capital Association describes venture capital as risk finance
for entrepreneurial growth oriented companies. It is an investment for the medium or
long term seeking to maximise the return.

Venture Capital, thus, implies an investment in the form of equity for high-risk projects
with the expectation of higher profits. The investments are made through private
placement with the expectation of risk of total loss or huge returns. High technology
industry is more attractive to venture capital financing due to the high profit potential.
The main object of investing equity is to get high capital profit at saturation stage.

In broad sense under venture capital financing venture capitalist makes investment
to purchase debt or equity from inexperienced entrepreneurs who undertake highly
risky ventures with potential of success.

h. Seed Capital Assistance : The seed capital assistance has been designed by IDBI for
professionally or technically qualified entrepreneurs. All the projects eligible for
financial assistance from IDBI, directly or indirectly through refinance are eligible under
the scheme.

The project cost should not exceed ` 2 crores and the maximum assistance under
the project will be restricted to 50% of the required promoters contribution or Rs
15 lacs whichever is lower.

The seed capital assistance is interest free but carries a security charge of one percent
per annum for the first five years and an increasing rate thereafter.

i. Global Depository Receipts and American Depository Receipts: Global Depository

Receipts (GDRs) are basically negotiable certificates denominated in US dollars
that represent a non-US company’s publicly traded local currency equity shares. These
are created when the local currency shares of Indian company are delivered to the
depository’s local custodian bank, against which the depository bank issues Depository
Receipts in US dollars.

Whereas, American Depository Receipts (ADR) are securities offered by non-US

companies who want to list on any of the US exchange. Each ADR represents a certain
number of a company's regular shares. ADRs allow US investors to buy shares of these
companies without the costs of investing directly in a foreign stock exchange. ADRs are
issued by an approved New York bank or trust company against the deposit of the
original shares. These are deposited in a custodial account in the US. Such receipts have

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to be issued in accordance with the provisions stipulated by the SEC USA which
are very stringent.

The Indian companies have preferred the GDRs to ADRs because the US market
exposes them to a higher level or responsibility than a European listing in the areas of
disclosure, costs, liabilities and timing.

j. Floating Rate Bonds: These are the bonds where the interest rate is not fixed
and is allowed to float depending upon the market conditions. These are ideal
instruments which can be resorted to by the issuers to hedge themselves against the
volatility in the interest rates. They have become more popular as a money market
instrument and have been successfully issued by financial institutions like IDBI, ICICI
etc.

k. Packing Credit: Packing credit is an advance made available by banks to an

exporter. Any exporter, having at hand a firm export order placed with him by his
foreign buyer on an irrevocable letter of credit opened in his favour, can approach a
bank for availing of packing credit. An advance so taken by an exporter is required to
be liquidated within 180 days from the date of its commencement by negotiation of
export bills or receipt of export proceeds in an approved manner. Thus Packing Credit is
essentially a short-term advance.

Normally, banks insist upon their customers to lodge the irrevocable letters of
credit opened in favour of the customer by the overseas buyers. The letter of credit and
firms’ sale contracts not only serve as evidence of a definite arrangement for realisation
of the export proceeds but also indicate the amount of finance required by the exporter.
Packing Credit, in the case of customers of long standing may also be granted against
firm contracts entered into by them with overseas buyers.

Question 6

State the different types of Packing Credit.

Answer :

Different Types of Packing Credit

Packing credit may be of the following types:

i. Clean Packing credit: This is an advance made available to an exporter only on

production of a firm export order or a letter of credit without exercising any charge or

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control over raw material or finished goods. It is a clean type of export advance. Each
proposal is weighted according to particular requirements of the trade and credit
worthiness of the exporter. A suitable margin has to be maintained. Also, Export
Credit Guarantee Corporation (ECGC) cover should be obtained by the bank.

ii. Packing credit against hypothecation of goods: Export finance is made available on
certain terms and conditions where the exporter has pledgeable interest and the goods
are hypothecated to the bank as security with stipulated margin. At the time of utilising
the advance, the exporter is required to submit alongwith the firm export order or
letter of credit, relative stock statements and thereafter continue submitting them every
fortnight and whenever there is any movement in stocks.

iii. Packing credit against pledge of goods: Export finance is made available on
certain terms and conditions where the exportable finished goods are pledged to the
banks with approved clearing agents who will ship the same from time to time as
required by the exporter. The possession of the goods so pledged lies with the bank and
is kept under its lock and key.

iv. E.C.G.C. guarantee: Any loan given to an exporter for the manufacture,
processing, purchasing, or packing of goods meant for export against a firm order
qualifies for the packing credit guarantee issued by Export Credit Guarantee
Corporation.

v. Forward exchange contract: Another requirement of packing credit facility is that if the
export bill is to be drawn in a foreign currency, the exporter should enter into a forward
exchange contact with the bank, thereby avoiding risk involved in a possible change in
the rate of exchange.

Question 7

Name the various financial instruments dealt with in the International market.

Answer :

Financial Instruments in the International Market

Some of the various financial instruments dealt with in the international market are:
a. Euro Bonds
b. Foreign Bonds
c. Fully Hedged Bonds
d. Medium Term Notes
e. Floating Rate Notes
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 TYPES OF FINANCING

f. External Commercial Borrowings

g. Foreign Currency Futures
h. Foreign Currency Option
i. Euro Commercial Papers.

Question 8

Discuss the advantages of raising funds by issue of equity shares.

Answer :

Advantages of Raising Funds by Issue of Equity Shares

i. It is a permanent source of finance. Since such shares are not redeemable, the company
has no liability for cash outflows associated with its redemption.
ii. Equity capital increases the company’s financial base and thus helps further the
borrowing powers of the company.
iii. The company is not obliged legally to pay dividends. Hence in times of uncertainties or
when the company is not performing well, dividend payments can be reduced or
even suspended.
iv. The company can make further issue of share capital by making a right issue.

Question 9

"Financing a business through borrowing is cheaper than using equity." Briefly explain.

Answer :

“Financing a business through borrowing is cheaper than using equity"

i. Debt capital is cheaper than equity capital from the point of its cost and interest
being deductible for income tax purpose, whereas no such deduction is allowed for
dividends.
ii. Issue of new equity dilutes existing control pattern while borrowing does not
result in dilution of control.
iii. In a period of rising prices, borrowing is advantageous. The fixed monetary
outgo decreases in real terms as the price level increases.

Question 10

State the main features of deep discount bonds.

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Answer :

Features of Deep Discount Bonds: Deep discount bonds are a form of zero-interest bonds.
These bonds are sold at discounted value and on maturity; face value is paid to the
investors. In such bonds, there is no interest payout during the lock- in period. The
investors can sell the bonds in stock market and realise the difference between face value
and market price as capital gain.

IDBI was the first to issue deep discount bonds in India in January 1993. The bond of a face
value of ` 1 lakh was sold for ` 2700 with a maturity period of 25 years.

Question 11

Explain in brief the features of Commercial Paper.

Answer :

Features of Commercial Paper (CP)

A commercial paper is an unsecured money market instrument issued in the form
of a promissory note. Since the CP represents an unsecured borrowing in the money
market, the regulation of CP comes under the purview of the Reserve Bank of India which
issued guidelines in 1990 on the basis of the recommendations of the Vaghul Working
Group. These guidelines were aimed at:
i. Enabling the highly rated corporate borrowers to diversify their sources of short
term borrowings, and
ii. To provide an additional instrument to the short term investors.

It can be issued for maturities between 7 days and a maximum upto one year from the date
of issue. These can be issued in denominations of ` 5 lakh or multiples therefore. All
eligible issuers are required to get the credit rating from credit rating agencies.

Question 12

Explain the term ‘Ploughing back of Profits’.

Answer :

Ploughing back of Profits : Long-term funds may also be provided by accumulating the
profits of the company and ploughing them back into business. Such funds belong to
the ordinary shareholders and increase the net worth of the company. A public limited

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company must plough back a reasonable amount of its profits each year keeping in view
the legal requirements in this regard and its own expansion plans. Such funds also entail
almost no risk. Further, control of present owners is also not diluted by retaining profits.

Question 13

Explain the concept of Indian depository receipts.

Answer :

Concept of Indian Depository Receipts: The concept of the depository receipt mechanism
which is used to raise funds in foreign currency has been applied in the Indian capital
market through the issue of Indian Depository Receipts (IDRs). Foreign companies can
issue IDRs to raise funds from Indian market on the same lines as an Indian company uses
ADRs/GDRs to raise foreign capital. The IDRs are listed and traded in India in the same
way as other Indian securities are traded.

Question 14

Discuss the features of Secured Premium Notes (SPNs).

Answer :

Secured premium notes are issued along with detachable warrants and are redeemable
after a notified period of say 4 to 7 years. This is a kind of NCD attached with warrant. It
was first introduced by TISCO, which issued the SPNs to existing shareholders on
right basis. Subsequently the SPNs will be repaid in some number of equal
instalments. The warrant attached to SPNs gives the holder the right to apply for and get
allotment of equity shares as per the conditions within the time period notified by the
company.

Question 15

Explain the concept of closed and open- ended lease.

Answer :

In the close-ended lease, the assets gets transferred to the lessor at the end of lease, the risk
of obsolescence, residual values etc. remain with the lessor being the legal owner of the

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CA INTER FINANCIAL MANAGEMENT

assets. In the open-ended lease, the lessee has the option of purchasing the assets at the end
of lease period.

Question 16

Distinguish between Operating lease and financial lease.

Answer :

Difference between Financial Lease and Operating Lease

[Link]. Finance Lease Operating Lease
1 The risk and reward incident to The lessee is only provided the use
ownership are passed on the lessee. of the asset for a certain time. Risk
The lessor only remains the legal incident to ownership belongs only
owner of the asset. to the lessor.
2 The lessee bears the risk of The lessor bears the risk of
obsolescence. obsolescence.
3 The lease is non-cancellable by The lease is kept cancellable by the
either party under it. lessor.

4 The lessor does not bear the cost of Usually, the lessor bears the cost of
repairs, maintenance or operations. repairs, maintenance or operations.
5 The lease is usually full payout. The lease is usually non-payout.

Question 17

State the main elements of leveraged lease.

Answer :

Main Elements of Leveraged Lease: Under this lease, a third party is involved beside lessor
and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the
third party i.e., lender. The asset so purchased is held as security against the loan. The
lender is paid off from the lease rentals directly by the lessee and the surplus after meeting
the claims of the lender goes to the lessor. The lessor is entitled to claim depreciation
allowance.

Question 18

Discuss the advantages of preference share capital as an instrument of raising funds.

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 TYPES OF FINANCING

Answer :

Advantages of Issue of Preference Shares are:

i. No dilution in EPS on enlarged capital base.
ii. There is no risk of takeover as the preference shareholders do not have voting rights.
iii. There is leveraging advantage as it bears a fixed charge.
iv. The preference dividends are fixed and pre-decided. Preference shareholders do not
participate in surplus profit as the ordinary shareholders
v. Preference capital can be redeemed after a specified period.

Question 19

Explain briefly the features of External Commercial Borrowings (ECBs).

Answer :

External Commercial Borrowings are loans taken from non-resident lenders in accordance
with exchange control regulations. These loans can be taken from:
 International banks
 Capital markets
 Multilateral financial institutions like IFC, ADB, IBRD etc.
 Export Credit Agencies
 Foreign collaborators
 Foreign Equity Holders.

ECBs can be accessed under automatic and approval routes depending upon the purpose
and volume.

In automatic there is no need for any approval from RBI / Government while approval is
required for areas such as textiles and steel sectors restructuring packages.

Question 20

Discuss the benefits to the originator of Debt Securitization.

Answer :

Benefits to the Originator of Debt Securitization

The benefits to the originator of debt securitization are as follows:

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CA INTER FINANCIAL MANAGEMENT

a. The assets are shifted off the balance sheet, thus giving the originator recourse to
off balance sheet funding.
b. It converts illiquid assets to liquid portfolio.
c. It facilitates better balance sheet management as assets are transferred off balance
sheet facilitating satisfaction of capital adequacy norms.
d. The originator's credit rating enhances.

Question 21

Differentiate between Factoring and Bills discounting.

Answer :

The differences between Factoring and Bills discounting are :

a. Factoring is called as “Invoice Factoring’ whereas Bills discounting is known as ‘Invoice

discounting.”
b. In Factoring, the parties are known as the client, factor and debtor whereas in Bills
discounting, they are known as drawer, drawee and payee.
c. Factoring is a sort of management of book debts whereas bills discounting is a sort of
borrowing from commercial banks.
d. For factoring there is no specific Act, whereas in the case of bills discounting, the
Negotiable Instruments Act is applicable.

Question 22

What is factoring? Enumerate the main advantages of factoring.

Answer :

Concept of Factoring and its Main Advantages: Factoring involves provision of specialized
services relating to credit investigation, sales ledger management purchase and collection
of debts, credit protection as well as provision of finance against receivables and risk
bearing. In factoring, accounts receivables are generally sold to a financial institution
(a subsidiary of commercial bank – called “factor”), who charges commission and bears
the credit risks associated with the accounts receivables purchased by it.

Advantages of Factoring

The main advantages of factoring are:

i. The firm can convert accounts receivables into cash without bothering about repayment.

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 TYPES OF FINANCING

ii. Factoring ensures a definite pattern of cash inflows.

iii. Continuous factoring virtually eliminates the need for the credit department. Factoring
is gaining popularity as useful source of financing short-term funds requirement of
business enterprises because of the inherent advantage of flexibility it affords to the
borrowing firm. The seller firm may continue to finance its receivables on a more or less
automatic basis. If sales expand or contract it can vary the financing proportionally.
iv. Unlike an unsecured loan, compensating balances are not required in this case. Another
advantage consists of relieving the borrowing firm of substantially credit and
collection costs and from a considerable part of cash management.

Question 23

Discuss the factors that a venture capitalist should consider before financing any risky
project.

Answer :

Factors to be considered by a Venture Capitalist before Financing any Risky Project

i. Quality of the management team is a very important factor to be considered.

They are required to show a high level of commitment to the project.
ii. The technical ability of the team is also vital. They should be able to develop and
produce a new product / service.
iii. Technical feasibility of the new product / service should be considered.
iv. Since the risk involved in investing in the company is quite high, venture capitalists
should ensure that the prospects for future profits compensate for the risk.
v. A research must be carried out to ensure that there is a market for the new product.
vi. The venture capitalist himself should have the capacity to bear risk or loss, if the
project fails.
vii. The venture capitalist should try to establish a number of exist routes.
viii. In case of companies, venture capitalist can seek for a place on the Board of Directors
to have a say on all significant matters affecting the business.

Question 24

What are Masala Bonds?

Source : ICAI, May 2018 Question Paper

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Answer :

Masala Bond
Masala (means spice) bond is an Indian name used for Rupee denominated bond
that Indian corporate borrowers can sell to investors in overseas markets. These bonds
are issued outside India but denominated in Indian Rupees. NTPC raised `2,000 crore
via masala bonds for its capital expenditure in the year 2016.

Question 25

What are the sources of short term financial requirement of the company?
Source : ICAI, May 2018 Question Paper
Answer :

There are various sources available to meet short-term needs of finance. The different
sources are discussed below:

i. Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of

sale. The usual duration of such credit is 15 to 90 days. It generates automatically in the
course of business and is common to almost all business operations. It can be in the
form of an 'open account' or 'bills payable'.

ii. Accrued Expenses and Deferred Income : Accrued expenses represent liabilities
which a company has to pay for the services which it has already received like wages,
taxes, interest and dividends.

iii. Advances from Customers : Manufacturers and contractors engaged in producing or

constructing costly goods involving considerable length of manufacturing or
construction time usually demand advance money from their customers at the time of
accepting their orders for executing their contracts or supplying the goods. This is a cost
free source of finance and really useful.

iv. Commercial Paper : A Commercial Paper is an unsecured money market instrument

issued in the form of a promissory note.

v. Treasury Bills : Treasury bills are a class of Central Government Securities. Treasury
bills, commonly referred to as T-Bills are issued by Government of India to meet short
term borrowing requirements with maturities ranging between 14 to 364 days.

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 TYPES OF FINANCING

vi. Certificates of Deposit (CD) : A certificate of deposit (CD) is basically a savings

certificate with a fixed maturity date of not less than 15 days up to a maximum of
one year.

[Link] Advances : Banks receive deposits from public for different periods at varying
rates of interest. These funds are invested and lent in such a manner that when
required, they may be called back.

Question 26

“Floating-rate bonds are designed to minimize the holders' interest rate risk; while
convertible bonds are designed to give the investor the ability to share in the price
appreciation of the company's stock.” Do you agree with this statement?
Source : ICAI, RTP May 2014 (Old)
Answer :

Floating rate bonds allow the investor to earn a rate of interest income tied to current
interest rates, thus negating one of the major disadvantages of fixed income investments
while Convertible bonds allow the investor to benefit from the appreciation of the stock
price, either by converting to stock or holding the bond, which will increase in price as the
stock price increases.

Question 27

Differentiate between Inflation Bonds and Floating Rate Bonds.

Source : ICAI, RTP May 2015 (Old)
Answer :

Inflation Bonds and Floating Rate Bonds : Inflation Bonds are the bonds in which interest
rate is adjusted for inflation. Thus, the investor gets interest which is free from the
effects of inflation. For example, if the interest rate is 11 per cent and the inflation is 5 per
cent, the investor will earn 16 per cent meaning thereby that the investor is protected
against inflation.

Floating Rate Bonds, as the name suggests, are the bonds where the interest rate is not fixed
and is allowed to float depending upon the market conditions. This is an ideal instrument
which can be resorted to by the issuer to hedge themselves against the volatility in the
interest rates. This has become more popular as a money market instrument and has been
successfully issued by financial institutions like IDBI, ICICI etc.

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 Chapter
FINANCIAL ANALYSIS
AND
3 PLANNING-RATIO ANALYSIS

LEARNING OUTCOMES
 Discuss Sources of financial data for Analysis.
 Discuss financial ratios and its Types.
 Discuss use of financial ratios to analyse the financial statement.
 Analyse the ratios from the perspective of investors, lenders, suppliers, managers
etc. to evaluate the profitability and financial position of an entity.
 Describe the users and objective of Financial Analysis:- A Birds Eye View.
 Discuss Du Pont analysis.
 State the limitations of Ratio Analysis.

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

CHAPTER OVERVIEW

RATIO ANALYSIS

Types of Application of Ratio

Ratio Analysis in decision
making

 Liquidity
Ratio/Short- term
solvency ratio
 Leverages Relationship of
Ratio/Short- term Financial Management
solvency ratios with other disciplines of
 Activity accounting
Ratio/Efficency
Ratio / Performance
 Ratio/Turnover
ratio Profitability
Ratios

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EXAMPLE

Question

XYZ Company’s details are as under:

Revenue : `29,261;
Net Income : `4,212;
Assets : `27,987;
Shareholders’ Equity : `13,572.

Calculate return on equity.

Source : ICAI, SM (New)
Answer :

Net Profit Margin = Net Income (`4,212) ÷ Revenue (`29,261) = 0.14439, or 14.39%
Asset Turnover = Revenue (`29,261) ÷ Assets (`27,987) = 1.0455
Equity Multiplier = Assets (` 27,987) ÷ Shareholders’ Equity (` 13,572) = 2.0621

Finally, we multiply the three components together to calculate the return on equity:
Return on Equity = Net Profit Margin × Asset Turnover × Equity Multiplier
= (0.1439) × (1.0455) × (2.0621) = 0.3102, or 31.02%

Analysis: A 31.02% return on equity is good in any industry. Yet, if you were to leave out
the equity multiplier to see how much company would earn if it were completely debt-free,
you will see that the ROE drops to 15.04%. 15.04% of the return on equity was due to profit
margins and sales, while 15.96% was due to returns earned on the debt at work in the
business. If you found a company at a comparable valuation with the same return on
equity yet a higher percentage arose from internally-generated sales, it would be more
attractive.

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

SUMMARY

 Financial Analysis and its Tools: For the purpose of obtaining the material
and relevant information necessary for ascertaining the financial strengths and
weaknesses of an enterprise, it is necessary to analyze the data depicted in
the financial statement. The financial manager has certain analytical tools which
help in financial analysis and planning. The main tools are Ratio Analysis and Cash
Flow Analysis.
 Ratio Analysis: The ratio analysis is based on the fact that a single
accounting figure by itself may not communicate any meaningful information
but when expressed as a relative to some other figure, it may definitely
provide some significant information. Ratio analysis is not just comparing different
numbers from the balance sheet, income statement, and cash flow statement. It
is comparing the number against previous years, other companies, the industry,
or even the economy in general for the purpose of financial analysis.
 Type of Ratios and Importance of Ratios Analysis: The ratios can be classified into
following four broad categories:
i. Liquidity Ratios
ii. Capital Structure/Leverage Ratios
iii. Activity Ratios
iv. Profitability Ratios
A popular technique of analyzing the performance of a business concern is that of
financial ratio analysis. As a tool of financial management, they are of crucial
significance. The importance of ratio analysis lies in the fact that it presents facts on a
comparative basis and enables drawing of inferences regarding the performance of a
firm.

Ratio analysis is relevant in assessing the performance of a firm in respect of

following aspects:
i. Liquidity Position
ii. Long-term Solvency
iii. Operating Efficiency
iv. Overall Profitability
v. Inter-firm Comparison
vi. Financial Ratios for Supporting Budgeting

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. Ratio of Net sales to Net working capital is a:

a. Profitability ratio
b. Liquidity ratio
c. Current ratio
d. Working capital turnover ratio

2. Long-term solvency is indicated by:

a. Debt/ equity ratio
b. Current Ratio
c. Operating ratio
d. Net profit ratio

3. Ratio of net profit before interest and tax to sales is:

a. Gross profit ratio
b. Net profit ratio
c. Operating profit ratio
d. Interest coverage ratio.

4. Observing changes in the financial variables across the years is:

a. Vertical analysis
b. Horizontal Analysis
c. Peer-firm Analysis
d. Industry Analysis.

5. The Receivable-Turnover ratio helps management to:

a. Managing resources
b. Managing inventory
c. Managing customer relationship
d. Managing working capital

ANSWERS

1. d 2. a
3. c 4. b
5. d

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

 ILLUSTRATIONS

Question 1

In a meeting held at Solan towards the end of 2016, the Directors of M/s HPCL Ltd. have
taken a decision to diversify. At present HPCL Ltd. sells all finished goods from its own
warehouse. The company issued debentures on 01.01.2017 and purchased fixed assets on
the same day. The purchase prices have remained stable during the concerned period.
Following information is provided to you:

Income Statements
Particulars 2016 ( ` ) 2017 ( ` )
Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Operating Expenses
Warehousing 13,000 14,000
Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 49,000 14,000
2,000 59,000
Net Profit 15,000 17,000

Balance Sheet
Assets & Liabilities 2016 ` 2017 `
Fixed Assets (Net Block) - 30,000 - 40,000
Receivables 50,000 82,000
Cash at Bank 10,000 7,000
Stock 60,000 94,000
Total Current Assets (CA) 1,20,000 1,83,000
Payables 50,000 76,000
Total Current Liabilities (CL) 50,000 76,000
Working Capital (CA - CL) 70,000 1,07,000
Total Assets 1,00,000 1,47,000
Represented by:
Share Capital 75,000 75,000
Reserve and Surplus 25,000 42,000
Debentures - 30,000
1,00,000 1,47,000
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CA INTER FINANCIAL MANAGEMENT

You are required to calculate the following ratios for the years 2016/2017.
1. Gross Profit Ratio
2. Operating Expenses to Sales Ratio.
3. Operating Profit Ratio
4. Capital Turnover Ratio
5. Stock Turnover Ratio
6. Net Profit to Net Worth Ratio, and
7. Receivables Collection Period.

Receivables Collection Period. Ratio relating to capital employed should be based on the
capital at the end of the year. Give the reasons for change in the ratios for 2 years. Assume
opening stock of ` 40,000 for the year 2017. Ignore Taxation.
Source : ICAI, SM (New)
Answer :

Computation of Ratios
1. Gross profit ratio 2016 2017
Gross profit/sales 64,000 × 100 76,000 ×100
3,00,000 3,74,000
21.3% 20.3%
2. Operating expense to sales ratio
Operating exp / Total sales 49,000×100 57,000 ×100
3,00,000 3,74,000
16.3% 15.2%
3. Operating profit ratio
Operating profit / Total sales 15,000  100 19,000 ×100
3,00,000 3,74,000
5% 5.08%
4. Capital turnover ratio
Sales / capital employed 3,00,000 3,74,000
3  2.54
1,00,000 1,47,000
5. Stock turnover ratio
COGS / Average stock 2,36,000 2,98,000
 4.7  3.9
50,000 77, 000
6. Net Profit to Networth
Net profit / Networth 15,000 ×100 17,000 ×100
 15%  14.5%
1,00,000 1,17,000
7. Receivables collection period
Average receivables / Average daily 50,000 82,000
sales (Refer to working note) 739.73 936.99
67.6 days 87.5 days

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Working note:
2,70,000 3,42,000
Average daily sales = Credit sales / 365
365 365
` 739.73 ` 936.99

Analysis: The decline in the Gross profit ratio could be either due to a reduction in the
selling price or increase in the direct expenses (since the purchase price has remained the
same). Similarly there is a decline in the ratio of operating expenses to sales. However since
operating expenses have little bearing with sales, a decline in this ratio cannot be
necessarily be interpreted as an increase in operational efficiency. An in-depth analysis
reveals that the decline in the warehousing and the administrative expenses has been partly
set off by an increase in the transport and the selling expenses. The operating profit ratio
has remained the same in spite of a decline in the Gross profit margin ratio. In fact
the company has not benefited at all in terms of operational performance because of the
increased sales.

The company has not been able to deploy its capital efficiently. This is indicated by a
decline in the Capital turnover from 3 to 2.5 times. In case the capital turnover would have
remained at 3 the company would have increased sales and profits by ` 67,000 and ` 3,350
respectively.

The decline in the stock turnover ratio implies that the company has increased its
investment in stock. Return on Net worth has declined indicating that the additional capital
employed has failed to increase the volume of sales proportionately. The increase in
the Average collection period indicates that the company has become liberal in
extending credit on sales. However, there is a corresponding increase in the current assets
due to such a policy.

It appears as if the decision to expand the business has not shown the desired results.

Question 2

Following is the abridged Balance Sheet of Alpha Ltd. :

Liabilities ` Assets ` `
Share Capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machineries 50,000
Current Liabilities 40,000 Less: Depreciation 15,000 35,000
1,15,000
Stock 21,000
Receivables 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000

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CA INTER FINANCIAL MANAGEMENT

With the help of the additional information furnished below, you are required to prepare
Trading and Profit & Loss Account and a Balance Sheet as at 31st March, 2017:
i. The company went in for reorganisation of capital structure, with share capital
remaining the same as follows:
Share capital 50%
Other Shareholders’ funds 15%
5% Debentures 10%
Payables 25%
Debentures were issued on 1st April, interest being paid annually on 31st March.
ii. Land and Buildings remained unchanged. Additional plant and machinery has
been bought and a further ` 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total fixed and current assets.)
iii. Working capital ratio was 8 : 5.
iv. Quick assets ratio was 1 : 1.
v. The receivables (four-fifth of the quick assets) to sales ratio revealed a credit period of
2 months. There were no cash sales.
vi. Return on net worth was 10%.
vii. Gross profit was at the rate of 15% of selling price.
viii. Stock turnover was eight times for the year.
Ignore Taxation.
Source : ICAI, SM (New)
Answer :

Particulars % (` )
Share capital 50% 1,00,000
Other shareholders funds 15% 30,000
5% Debentures 10% 20,000
Payables 25% 50,000
Total 100% 2,00,000

Land and Buildings

Total liabilities = Total Assets
` 2,00,000 = Total Assets
Fixed Assets = 60% of total fixed assets and current assets
= ` 2,00,000 x 60/100 = ` 1,20,000

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Calculation of additions to Plant & Machinery

`
Total fixed assets 1,20,000
Less: Land & Buildings 80,000
Plant and Machinery (after providing depreciation) 40,000
Depreciation on Machinery up to 31-3-20  2 15,000
Add: Further depreciation 5,000
Total 20,000

Current assets = Total assets – Fixed assets

= ` 2,00,000 – ` 1,20,000 = ` 80,000

Calculation of stock
Current assets - stock
Quick ratio = 1
Current liabilities
80,000 - stock
= 1
50,000
` 50,000 = ` 80,000 – Stock
Stock = ` 80,000 - ` 50,000
= ` 30,000
Receivables = 4/5th of quick assets
= (` 80,000 – 30,000)  4/5
= ` 40,000

Receivables turnover ratio

Receivables
=  365 days = 60 days
Credit Sales
40,000 ×12
=  365 = 2 months
Credit Sales
2 credit sales = 4,80,000 Credit sales
= 4,80,000/2
= 2,40,000
Gross profit (15% of sales)
` 2,40,000 x 15/100 = ` 36,000

Return on net worth (net profit)

Net worth = ` 1,00,000 + ` 30,000
= ` 1,30,000
Net profit = ` 1,30,000 x 10/100 = ` 13,000
Debenture interest = ` 20,000 x 5/100 = ` 1,000

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CA INTER FINANCIAL MANAGEMENT

Projected profit and loss account for the year ended 31-3-2017
To cost of goods sold 2,04,000 By sales 2,40,000
To gross profit 36,000
Total 2,40,000 Total 2,40,000
To debenture interest 1,000 By gross profit 36,000
To administration and other expenses 22,000
To net profit 13,000
Total 36,000 Total 36,000

Projected Balance Sheet as at 31st March, 2017

Liabilities ` Assets `
Share capital 1,00,000 Fixed assets
Profit and loss A/c 30,000 Land & buildings 80,000
(17,000+13,000)
5% Debentures 20,000 Plant & machinery 60,000
Current liabilities Less: Depreciation 20,000 40,000
Trade creditors 50,000 Stock 30,000
Debtors 40,000
Bank 10,000 80,000
2,00,000 2,00,000

Question 3

X Co. has made plans for the next year. It is estimated that the company will employ total
assets of ` 8,00,000; 50 per cent of the assets being financed by borrowed capital at an
interest cost of 8 per cent per year. The direct costs for the year are estimated at ` 4,80,000
and all other operating expenses are estimated at ` 80,000. the goods will be sold to
customers at 150 per cent of the direct costs. Tax rate is assumed to be 50 per cent.

You are required to calculate:

(i) net profit margin
(ii) return on assets
(iii) asset turnover and
(iv) return on owners’ equity.
Source : ICAI, SM (New)

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Answer :

The net profit is calculated as follows:

Particulars ` `
Sales (150% of ` 4,80,000) 7,20,000
Direct costs 4,80,000
Gross profit 2,40,000
Operating expenses 80,000
Interest changes (8% of ` 4,00,000) 32,000 1,12,000
Profit before taxes 1,28,000
Taxes (@ 50%) 64,000
Net profit after taxes 64,000

Profit after taxes 64, 000

i. Net profit margin =   0.89 or 8.9%
Sales 7, 20, 000
EBIT(1 - T) ` 1,60,000(1- 0.5)
Net profit margin =  = 0.111 or 11.1%
Sales 7,20,000

EBIT(1 - T) ` 1,60,000(1- 0.5)

ii. Return on assets =  = 0.10 or 10%
Assets 8,00,000

Sales `7,20,000
iii. Asset turnover =  = 0.9 times
Assets ` 8,00,000

Net Profit after taxes ` 64,000

iv. Return on equity = 
Owners' equity 50% of ` 8,00,000
` 64,000
= = 0.16 or 16%
` 4,00,000

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CA INTER FINANCIAL MANAGEMENT

Question 4

ABC Company sells plumbing fixtures on terms of 2/10, net 30. Its financial statements
over the last 3 years are as follows:
2015 2016 2017
Particular
(`) (`) (`)
Cash 30,000 20,000 5,000
Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000 6,00,000
Net fixed assets 8,00,000 8,00,000 8,00,000
14,30,000 15,60,000 16,95,000
(`) (`) (`)
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long-term debt 3,00,000 3,00,000 3,00,000
Common stock 1,00,000 1,00,000 1,00,000
Retained earnings 5,00,000 5,50,000 5,50,000
14,30,000 15,60,000 16,95,000
(`) (`) (`)
Sales 40,00,000 43,00,000 38,00,000
Cost of goods sold 32,00,000 36,00,000 33,00,000
Net profit 3,00,000 2,00,000 1,00,000

Analyse the company’s financial condition and performance over the last 3 years. Are there
any problems?
Source : ICAI, SM (New)
Answer :
Ratios 2015 2016 2017
Current ratio 1.19 1.25 1.20
Acid-test ratio 0.43 0.46 0.40
Average collection period 18 22 27
Inventory turnover NA* 8.2 6.1
Total debt to net worth 1.38 1.40 1.61
Long-term debt to total capitalization 0.33 0.32 0.32
Gross profit margin 0.200 0.163 0.132
Net profit margin 0.075 0.047 0.026
Asset turnover 2.80 2.76 2.24
Return on assets 0.21 0.13 0.06

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Analysis : The company’s profitability has declined steadily over the period. As only
` 50,000 is added to retained earnings, the company must be paying substantial
dividends. Receivables are growing slower, although the average collection period is still
very reasonable relative to the terms given. Inventory turnover is slowing as well,
indicating a relative buildup in inventories. The increase in receivables and inventories,
coupled with the fact that net worth has increased very little, has resulted in the total debt-
to-worth ratio increasing to what would have to be regarded on an absolute basis as a high
level.

The current and acid-test ratios have fluctuated, but the current ratio is not particularly
inspiring. The lack of deterioration in these ratios is clouded by the relative build up in both
receivables and inventories, evidencing deterioration in the liquidity of these two assets.
Both the gross profit and net profit margins have declined substantially. The relationship
between the two suggests that the company has reduced relative expenses in 2016 in
particular. The build up in inventories and receivables has resulted in a decline in the asset
turnover ratio, and this, coupled with the decline in profitability, has resulted in a sharp
decrease in the return on assets ratio.

Question 5

Following informations are available for Navya Ltd. along with various ratio relevant to the
particulars industry it belongs to. Gives your comments on strength and weakness of
Navya Ltd. comparing its ratios with the given industry norms.

Navya Ltd.
Balance Sheet as at 31.3.2017
Amount Amount
Liabilities Assets
(`) (`)
Equity Share Capital 48,00,000 Fixed Assets 24,20,000
10% Debentures 9,20,0000 Cash 8,80,000
Sundry Creditors 6,60,000 Sundry debtors 11,00,000
Bills Payable 8,80,000 Stock 33,00,000
Other current Liabilities 4,40,000 -
Total 77,00,000 Total 77,00,000

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Statement of Profitability
For the year ending 31.3.2017
Particulars Amount Amount (`)
(`)
Sales 1,10,00,000
Less: Cost of goods sold: - -
Material 41,80,000 -
Wages 26,40,000 -
Factory Overhead 12,98,000 81,18,000
Gross Profit - 28,82,000
Less: Selling and Distribution Cost 11,00,000 -
Administrative Cost 12,28,000 23,28,000
Earnings before Interest and Taxes - 5,54,000
Less: Interest Charges - 92,000
Earning before Tax - 4,62,000
Less: Taxes & 50% - 2,31,000
Net Profit (PAT) 2,31,000

Industry Norms
Ratios Norm
Current Assets/Current Liabilities 2.5
Sales/ debtors 8.0
Sales/ Stock 9.0
Sales/ Total Assets 2.0
Net Profit/ Sales 3.5%
Net profit /Total Assets 7.0%
Net Profit/ Net Worth 10.5%
Total Debt/Total Assets 60.0%
Source : ICAI, SM (New)
Answer :

Ratios Navya Ltd. Industry Norms

Current Assets 52,800
1.  2.60 2.50
Current Liabilities 19,800
Sales 1,10,000 8.00
2.  10.0
Debtors 11, 000

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Sales 1,10,000 9.00

3.  3.33
Stock 33,000
Sales 1,10,000 2.00
4.  1.43
Total Assets 77,000
Net Profit 2,32,000 3.50%
5.  2.11%
Sales 1,10,000
Net Profit 2,32,000 7%
6.  3.01%
Total Assets 77,000
Net Profit 2,32,000 10.5%
7.  4.65%
Net Worth 49,86,000
Total Debt 29,000 60%
8.  37.66%
Total Assets 77, 000

Comments:
1. The position of Navya Ltd. is better than the industry norm with respect to Current
Ratios and the Sales to Debtors Ratio.
2. However, the position of sales to stock and sales to total assets is poor comparing to
industry norm.
3. The firm also has its net profit ratios , net profit to total assets and net profit to total
worth ratio much lower than the industry norm.
4. Total debt to total assets ratio suggest that, the firm is geared at lower level and debt are
used to Asset.

Question 6

The total sales (all credit) of a firm are ` 6,40,000. It has a gross profit margin of 15 per cent
and a current ratio of 2.5. The firm’s current liabilities are ` 96,000; inventories ` 48,000 and
cash ` 16,000.
a. Determine the average inventory to be carried by the firm, if an inventory turnover of
5 times is expected? (Assume a 360 day year).
b. Determine the average collection period if the opening balance of debtors is intended
to be of ` 80,000? (Assume a 360 day year).
Source : ICAI, SM (Old)
Answer :

Cost of goods sold

a. Inventory turnover =
Average inventory

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Since gross profit margin is 15 per cent, the cost of goods sold should be 85 per cent of
the sales.
Cost of goods sold = 0.85 × ` 6,40,000 = ` 5,44,000.
` 5,44,000
Thus, = 5
Average inventory
` 5,44,000
Average inventory =  ` 1,08,800
5

Average Receivables
b. Average collection period =  360 days
Credit Sales
(Opening Receivables Closing Receivables)
Average Receivables =
2
Closing balance of receivables is found as follows:
` `
Current assets (2.5 of current liabilities) 2,40,000
Less: Inventories 48,000
Cash 16,000 64,000
∴ Receivables 1,76,000

Average Receivables =
 ` 1,76, 000  ` 80, 000 
2
= ` 2,56,000 ÷2 = ` 1,28,000
` 1,28,000
Average collection period =  360  72 days
` 6,40,000

Question 7

The capital structure of Beta Limited is as follows:

Equity share capital of Rs. 10 each 8,00,000
9% preference share capital of Rs. 10 each 3,00,000
11,00,000

Additional information: Profit (after tax at 35 per cent), ` 2,70,000; Depreciation,

` 60,000; Equity dividend paid, 20 per cent; Market price of equity shares, ` 40.

You are required to compute the following, showing the necessary workings:
a. Dividend yield on the equity shares
b. Cover for the preference and equity dividends
c. Earnings per shares
d. Price-earnings ratio.
Source : ICAI, SM (Old)
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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Answer :

a. Dividend yield on the equity shares

Dividend per share ` 2(0.20  ` 10)
 100 =  100  5 percent
Market price per share ` 40

b. Dividend coverage ratio

Profit after taxes
i. Preference=
Dividend payable to preference shareholders
` 2, 70, 000
= = 10 times
` 27, 000 (  0.09  ` 3, 00, 000)
Profit after taxes - Preference share dividend
ii. Equity =
Dividend payable to equity shareholders at current rate of Rs. 2 per share
` 2,70, 000  ` 27, 000
= = 1.52 times
` 1, 60, 000 (80, 000 shares  ` 2)

Earnings available to equity shareholders

c. Earnings per equity share =
Number of equity shares outs tanding
` 2,43,000
=  ` 3.04 per share
80,000

Market price per share ` 40

d. Price-earning (P/E) ratio = =  13.2 times
Equity per share ` 3.04

Question 8

The following accounting information and financial ratios of PQR Ltd. relate to the year
ended 31st December, 2013:
2013
I. Accounting Information:
Gross Profit 15% of Sales
Net profit 8% of sales
Raw materials consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit

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II. Financial Ratios:

Fixed assets to sales 1:3
Fixed assets to Current assets 13 : 11
Current ratio 2:1
Long-term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4

If value of fixed assets as on 31st December, 2012 amounted to ` 26 lakhs, prepare a

summarised Profit and Loss Account of the company for the year ended 31st December,
2013 and also the Balance Sheet as on 31st December, 2013.
Source : ICAI, SM (Old)
Answer :

a. Working Notes:
Fixed Assets 1
i. Calculation of Sales = 
Sales 3
26,00,000 1
∴   Sale = ` 78,00,000
Sale 3

Fixed Assets 13
ii. Calculation of Current Assets = 
Current Assets 11
26,00,000 13
∴   Current Assets = ` 22,00,000
Current Assets 11

iii. Calculation of Raw Material Consumption and Direct Wages

`
Sales 78,00,000
Less: Gross Profit 11,70,000
Works Cost 66,30,000
Raw Material Consumption (20% of Works Cost) ` 13,26,000
Direct Wages (10% of Works Cost) ` 6,63,000

iv. Calculation of Stock of Raw Materials (= 3 months usage)

3
= 13,26,000  ` 3,31,500
12
v. Calculation of Stock of Finished Goods (= 6% of Works Cost)
6
= 66,30,000  ` 3,97,800
12

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vi. Calculation of Current Liabilities

Current Assets
= 2
Current Liabilities
22,00,000
=  2  Current Liabilities ` 11, 00, 000
Current Liabilities

[Link] of Receivables
Receivables
Average collection period =  365
Credit Sales
Receivables
 365  60  Receivables = `12,82,191.78 or 12,82,192
78, 00, 000

[Link] of Long term Loan

Long term Loan 2
= 
Current Liabilities 1
Long term loan 2
=   Long term loan = ` 22,00,000
11, 00, 000 1

ix. Calculation of Cash Balance

`
Current assets 22,00,000
Less: Receivables 12,82,192
Raw materials stock 3,31,500
Finished goods stock 3,97,800 20,11,492
Cash balance 1,88,508

x. Calculation of Net worth

Fixed Assets 26,00,000
Current Assets 22,00,000
Total Assets 48,00,000
Less: Long term Loan 22,00,000
Current Liabilities 11,00,000 33,00,000
Net worth 15,00,000
Net worth = Share capital + Reserves = 15,00,000
Capital 1 1
  Share Capital = 15,00,000  ` 3, 00, 000
Reserves and Surplus 4 5
4
Reserves and Surplus 15,00,000  ` 12, 00, 000
5

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Profit and Loss Account of PQR Ltd.

for the year ended 31st December, 2013
Amount Amount
Particulars Particulars
(`) (`)
To Direct Materials 13,26,000 By Sales 78,00,000
To Direct Wages 6,63,000
To Works (Overhead) 46,41,000
Balancing figure
To Gross Profit c/d (15% of Sales) 11,70,000
78,00,000 78,00,000
To Selling and Distribution 5,46,000 By Gross Profit 11,70,000
Expenses
(Balancing figure)
To Net Profit (8% of Sales) 6,24,000
11,70,000

Balance Sheet of PQR Ltd.

as at 31st December, 2013
Amount Amount
Liabilities Assets
(`) (`)
Share Capital 3,00,000 Fixed Assets 26,00,000
Reserves and Surplus 12,00,000 Current Assets:
Long term loans 22,00,000 Stock of Raw Material 3,31,500
Stock of Finished Goods 3,97,800
Current liabilities 11,00,000
Receivables 12,82,192
Cash 1,88,508
48,00,000 48,00,000

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Question 9

Ganpati Limited has furnished the following ratios and information relating to the year
ended 31st March, 2013.
Sales ` 60,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 7:3
Current ratio 2

Net profit to sales 6.25%

Inventory turnover (based on cost of goods sold) 12
Cost of goods sold ` 18,00,000
Interest on debentures ` 60,000
Receivables ` 2,00,000
Payables ` 2,00,000

You are required to:

a. Calculate the operating expenses for the year ended 31st March, 2013.
b. Prepare a balance sheet as on 31st March in the following format:

Balance Sheet as on 31st March, 2013

Liabilities ` Assets `
Share Capital Fixed Assets
Reserve and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Cash
Source : ICAI, SM (Old)

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Answer :

a. Calculation of Operating Expenses for the year ended 31st March, 2013.
Amount Amount
(`) (`)
Net Profit [@ 6.25% of Sales] 3,75,000
Add: Income Tax (@ 50%) 3,75,000
Profit Before Tax (PBT) 7,50,000
Add: Debenture Interest 60,000
Profit before interest and tax (PBIT) 8,10,000
Sales 60,00,000
Less: Cost of goods sold 18,00,000
PBIT 8,10,000 26,10,000
Operating Expenses 33,90,000

b. Balance Sheet as on 31st March 2013

Amount Amount
Liabilities Assets
(`) (`)
Share Capital 10,50,000 Fixed Assets 17,00,000
Reserve and Surplus 4,50,000 Current Assets:
15% Debentures 4,00,000 Stock 1,50,000
Payables 2,00,000 Receivables 2,00,000
Cash 50,000
21,00,000 21,00,000

Working Notes:

i. Share Capital and Reserves

The return on net worth is 25%. Therefore, the profit after tax of ` 3,75,000 should be
equivalent to 25% of the net worth.
25
Net Worth  ` 3,75, 000
100
` 3,75, 000  100
∴ Net worth =  ` 15, 00, 000
25
The ratio of share capital to reserves is 7:3
7
Share Capital = 15,00,000  = `10,50,000
10
3
Reserves= 15,00,000  ` 4, 50, 000
10
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ii. Debentures
Interest on Debentures @ 15% = ` 60,000
` 60, 000  100
∴Debentures =  ` 4, 00, 000
15
iii. Current Assets
Current Ratio = 2
Payables = ` 2,00,000
∴ Current Assets = 2  Current Liabilities = 2  2,00,000 = ` 4,00,000

iv. Fixed Assets

Amount
Liabilities
(`)
Share capital 10,50,000
Reserves 4,50,000
Debentures 4,00,000
Payables 2,00,000
21,00,000
Less : Current Assets 4,00,000
Fixed Assets 4,00,000

v. Composition of Current Assets

Inventory Turnover = 12
Cost of goods sold
 12
Closing stock
` 18,00,000
Closing stock =  Closing stock = ` 1,50,000
12

Amount
Composition
(`)
Stock 1,50,000
Receivables 2,00,000
Cash (balancing figure) 50,000
Total Current Assets 4,00,000

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Question 10

Using the following information, complete this balance sheet:

Long-term debt to net worth 0.5 to 1
Total asset turnover 2.5 
Average collection period* 18 days
Inventory turnover 9
Gross profit margin 10%
Acid-test ratio 1 to 1
*Assume a 360-day year and all sales on credit.

` `
Cash _______ Notes and payables 1,00,000
Accounts receivable ______ Long-term debt ___________
Inventory _______ Common stock 1,00,000
Plant and equipment _______ Retained earnings 1,00,000
Total assets _______ Total liabilities and equity ___________
Source : ICAI, SM (Old)
Answer :

Long-term debt Long-term debt

 0.5 
Net worth 2,00,000
Long-term debt = ` 1,00,000
Total liabilities and net worth = ` 4,00,000
Total assets = ` 4,00,000
Sales Sales
 2.5   Sales ` 10, 00, 000
Total assets 4, 00, 000
Cost of goods sold = (0.9) (` 10,00,000) = ` 9,00,000.
Cost of goods sold 9, 00, 000
  9  Inventory = ` 1,00,000
Inventory Inventory
Receivables × 360
 18 days
10,00,000
Receivables = ` 50,000
Cash + 50,000
1
1, 00, 000
Cash = ` 50,000
Plant and equipment = ` 2,00,000.

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Balance Sheet
Amount Amount
Liabilities Assets
(`) (`)
Cash 50,000 Notes and payables 1,00,000
Accounts receivable 50,000 Long-term debt 1,00,000
Inventory 1,00,000 Common stock 1,00,000
Plant and equipment 2,00,000 Retained earnings 1,00,000
Total assets 4,00,000 Total liabilities and equity 4,00,000

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 PRACTICE QUESTIONS

Source : ICAI, PM (Old) - (From Question No. 1 - 10 )

Question 1

From the following information, prepare a summarised Balance Sheet as at 31st March,
2002:
Net Working Capital ` 2,40,000
Bank overdraft ` 40,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus ` 1,60,000
Current ratio 2.5 Liquid ratio
(Quick Ratio) 1.5

Answer :

Working notes:
1. Current assets and Current liabilities computation:
Current assets 2.5

Current liabilities 1
Or Current assets = 2.5 Current liabilities
Now, Working capital = Current assets - Current liabilities
Or `2,40,000 = 2.5 Current liability - Current liability
Or 1.5 Current liability = ` 2,40,000
∴ Current liabilities = ` 1,60,000
So, Current assets = ` 1,60,000  2.5 = ` 4,00,000

2. Computation of stock
Liquid assets
Liquid ratio =
Current liabilities
Current assets - Inventories
Or 1.5 =
` 1,60,000
Or 1.5  ` 1, 60,000 = ` 4,00,000 - Inventories
Or Inventories = `4, 00,000 – ` 2, 40,000
Or Stock = ` 1, 60,000

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

3. Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors

Fixed assets
Fixed Asset to Proprietary ratio =  0.75
Proprietary fund
∴Fixed assets = 0.75 Proprietary fund (PF) [FA + NWC = PF
or NWC = PF- FA (i.e. .75 PF)]
and Net working capital (NWC) = 0.25 Proprietary fund
Or ` 2,40,000/0.25 = Proprietary fund
Or Proprietary = ` 9,60,000
and Fixed Assets = 0.75 proprietary fund
= 0.75 ` 9,60,000
= ` 7,20,000

Capital = Proprietary fund - Reserves & Surplus

= ` 9,60,000 - ` 1,60,000 =` 8,00,000

Sundry creditors = (Current liabilities - Bank overdraft)

= (` 1,60,000 - ` 40,000) = ` 1,20,000

Balance Sheet
Amount Amount
Liabilities Assets
(`) (`)
Capital 8,00,000 Fixed assets 7,20,000
Reserves & Surplus 1,60,000 Stock 1,60,000
Bank overdraft 40,000 Current assets 2,40,000
Sundry creditors 1,20,000
11,20,000 11,20,000

Question 2

With the help of the following information complete the Balance Sheet of MNOP Ltd.:
Equity share capital ` 1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt 0.40
Total debt to Equity share capital 0.60
Fixed assets to Equity share capital 0.60
Total assets turnover 2 Times
Inventory turnover 8 Times

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Answer :

MNOP Ltd.
Balance Sheet
Amount Amount
Liabilities Assets
(`) (`)
Equity share capital 1,00,000 Fixed assets 60,000
Current debt 24,000 Cash (balancing figure) 60,000
Long term debt 36,000 Inventory 40,000
1,60,000 1,60,000

Working Notes

1. Total debt = 0.60  Equity share capital = 0.60  ` 1,00,000 = ` 60,000

Further, Current debt to total debt = 0.40. So, current debt = 0.40 × `60,000 = `24,000,
Long term debt = `60,000 - `24,000= ` 36,000

2. Fixed assets = 0.60 × Equity share Capital = 0.60 × ` 1,00,000 = ` 60,000

3. Total assets to turnover = 2 Times : Inventory turnover = 8 Times

Hence, Inventory /Total assets = 2/8=1/4, Total assets = ` 1,60,000
Therefore Inventory = ` 1,60,000/4 = ` 40,000

Question 3

JKL Limited has the following Balance Sheets as on March 31, 2015 and March 31, 2016:
Balance Sheet
` in lakhs
March 31, March 31,
2015 2016
Sources of Funds:
Shareholders Funds 2,377 1,472
Loan Funds 3,570 3,083
5,947 4,555
Applications of Funds:
Fixed Assets 3,466 2,900
Cash and bank 489 470
Debtors 1,495 1,168
Stock 2,867 2,407
Other Current Assets 1,567 1,404
Less: Current Liabilities (3,937) (3,794)
5,947 4,555

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 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

The Income Statement of the JKL Ltd. for the year ended is as follows:
` in lakhs
March 31, March 31,
2015 2016
Sales 22,165 13,882
Less: Cost of Goods sold 20,860 12,544
Gross Profit 1,305 1,338
Less: Selling, General and Administrative expenses 1,135 752
Earnings before Interest and Tax (EBIT) 170 586
Interest Expense 113 105
Profits before Tax 57 481
Tax 23 192
Profits after Tax (PAT) 34 289

Required:
i. Calculate for the year 2015-16:
a. Inventory turnover ratio
b. Financial Leverage
c. Return on Capital Employed (ROCE)
d. Return on Equity (ROE)
e. Average Collection period.
ii. Give a brief comment on the Financial Position of JKL Limited.

Answer :

Ratios for the year 2015-2016

i.
a. Inventory turnover ratio
COGS 20,860
=   7.91
Average Inventory (2,867 + 2,407)
2
b. Financial Leverage
2015-16 2014-15
EBIT 170 586
= 2.98  1.22
EBIT  I 57 481

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c. ROCE
EBIT  1  t  57  1  0.4  34.2
    100  0.651%
Average Capital Employed  5,947 + 4,535  5251
 
 2 
[Here Return on Capital Employed (ROCE) is calculated after Tax]

d. ROE
Profits after tax 34 34
=    1.77%
Average shareholders' funds  2, 377  1, 472  1, 924.5
2
e. Average Collection Period*
22, 165
Average Sales per day = ` 60.73 lakhs
365
Average collection period
(1,495 + 1,168)
Average Debtors 2 1331.5
=    22 days
Average sales per day 60.73 60.73

*Note: In the above solution, 1 year = 365 days has been assumed. Alternatively, it
may be solved on the basis of 1 year = 360 days.

ii. Brief Comment on the financial position of JKL Ltd.

The profitability of operations of the company are showing sharp decline due to
increase in operating expenses. The financial and operating leverages are becoming
adverse.
The liquidity of the company is under great stress.

Question 4

Using the following information, complete the Balance Sheet given below:
i. Total debt to net worth 1:2
ii. Total asset turnover 2
iii. Gross profit on sales 30%
iv. Average collection period (Assume 360 days in a year) 40 days
v. Inventory turnover ratio based on cost of goods sold and year-end 3
inventory
vi. Acid test ratio 0.75

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Balance Sheet
as on March 31, 2016
Amount Amount
Liabilities Assets
(`) (`)
Equity Shares Capital 4,00,000 Plant and Machinery and -
other Fixed Assets
Reserves and Surplus 6,00,000 Current Assets:

Total Debt: Inventory -

Current Liabilities - Debtors -
Cash -

Answer :

Net worth = Capital + Reserves and surplus

= `4,00,000 + `6,00,000 = `10,00,000
Total Debt 1
= 
Networth 2
∴Total debt = ` 5,00,000
Total Liability side = ` 4,00,000 + ` 6,00,000 + ` 5,00,000
= ` 15,00,000
= Total Assets
Sales
Total Assets Turnover =
Total Assets
Sales
2 =
` 15,00,000
∴ Sales = ` 30,00,000
Gross Profit on Sales : 30% i.e. ` 9,00,000
∴Cost of Goods Sold (COGS) = ` 30,00,000 – ` 9,00,000
= ` 21,00,000
COGS
Inventory turnover =
Inventory
` 21,00,000
3 =
Inventory
∴Inventory = ` 7,00,000
Average debtors
Average collection period =
Sales / day
Debtors
40 =
` 30,00,000 / 360

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∴ Debtors = ` 3,33,333.
Current Assets - Stock (Quick Asset)
Acid test ratio =
Current liabilities
Current Assets - `7,00,000
0.75 =
` 5, 00, 000
∴ Current Assets = `10,75,000.

∴ Fixed Assets = Total Assets – Current Assets

= ` 15,00,000 – ` 10,75,000 = ` 4,25,000

Cash and Bank balance = Current Assets – Inventory – Debtors

= ` 10,75,000 – ` 7,00,000 – ` 3,33,333 = ` 41,667.

Balance Sheet as on March 31, 2016

Amount Amount
Liabilities Assets
(`) (`)
Plant and Machinery and
Equity Share Capital 4,00,000 4,25,000
other Fixed Assets
Reserves & Surplus 6,00,000 Current Assets:
Total Debt: Inventory 7,00,000
Current liabilities 5,00,000 Debtors 3,33,333
Cash 41,667
15,00,000 15,00,000

Question 5

MN Limited gives you the following information related for the year ending 31st March,
2016:
1. Current Ratio 2.5
2. Debt-Equity Ratio 1 : 1.5
3. Return on Total Assets (After Tax) 15%
4. Total Assets Turnover Ratio 2
5. Gross Profit Ratio 20%
6. Stock Turnover Ratio 7
7. Current Market Price per Equity Share `16
8. Net Working Capital ` 4,50,000
9. Fixed Assets ` 10,00,000
10. 60,000 Equity Shares of ` 10 each
11. 20,000, 9% Preference Shares of ` 10 each
12. Opening Stock `3,80,000

SANJAY SARAF SIR 77

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

You are required to calculate:

i. Quick Ratio
ii. Fixed Assets Turnover Ratio
iii. Proprietary Ratio
iv. Earnings per Share
v. Price-Earning Ratio.

Answer :
Working Notes :

1. Net Working Capital = Current Assets – Current Liabilities

= 2.5 – 1=1.5
Net Working Capital × 2.5
Thus, Current Assets =
1.5
` 4,50,000 × 2.5
=  ` 7,50,000
1.5
Current Liabilities = ` 7,50,000 – ` 4,50,000 = ` 3,00,000

2. Sales = Total Assets Turnover × Total Assets

= 2 × (Fixed Assets + Current Assets)
= 2 × (` 10,00,000 + ` 7,50,000) = ` 35,00,000
3. Cost of Goods Sold = 100% – 20%= 80% of Sales
= 80% of ` 35,00,000 = ` 28,00,000

Cost of Goods Sold

4. Average Stock =
Stock Turnover Ratio
` 28,00,000
=  ` 4,00,000
7
Closing Stock = (Average Stock ×2) – Opening Stock
= (` 4,00,000 × 2) – ` 3,80,000 = ` 4,20,000
Quick Assets = Current Assets – Closing Stock
= ` 7,50,000 – ` 4,20,000 = ` 3,30,000
Debt 1
= , Or Proprietary fund = 1.5 Debt.
Equity (here Proprietary fund) 1.5
Total Asset = Proprietary Fund (Equity) + Debt
Or 17,50,000 = 1.5 Debt + Debt
`17,50, 000
Or Debt = = ` 7,00,000
2.5

SANJAY SARAF SIR 78

CA INTER FINANCIAL MANAGEMENT

Proprietary fund = 7, 00,000 × 1.5 = ` 10,50,000

` 17, 50, 000 ×1.5
= =` 10, 50, 000
2.5

5. Profit after tax (PAT) = Total Assets × Return on Total Assets

= ` 17,50,000 × 15% = ` 2,62,500

i. Calculation of Quick Ratio

Quick Assets `3,30,000
Quick Ratio = =  1.1:1
Current Liabilities 3,00,000

ii. Calculation of Fixed Assets Turnover Ratio

Sales ` 35,00,000
Fixed Assets Turnover Ratio = = = 3.5
Fixed Assets ` 10,00,000

iii. Calculation of Proprietary Ratio

Proprietary fund
Proprietary Ratio 
Total Assets
` 10,50, 000
= = 0.6 : 1
` 17,50,000

iv. Calculation of Earnings per Equity Share (EPS)

PAT - Preference Share Dividend
Earnings per Equity Share (EPS) =
Number of Equity Shares
` 2,62,500 - ` 18,000 (9% of 2,00,000)
=
60,000
= ` 4.075 per share

v. Calculation of Price-Earnings Ratio (P/E Ratio)

Market Price of Equity Share ` 16
P/E Ratio = =  3.926
EPS ` 4.075

SANJAY SARAF SIR 79

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Question 6

Using the following data, complete the Balance Sheet given below:
Gross Profit ` 54,000
Shareholders’ Funds ` 6,00,000
Gross Profit margin 20%
Credit sales to Total sales 80%
Total Assets turnover 0.3 times
Inventory turnover 4 times
Average collection period (a 360 days year) 20 days
Current ratio 1.8
Long-term Debt to Equity 40%

Balance Sheet
Amount Amount
Liabilities Assets
(`) (`)
Creditors - Cash -
Long-term debt - Debtors -
Shareholders’ funds - Inventory -
Fixed Assets -

Answer :

Gross Profit ` 54,000

Gross Profit Margin 20%
Gross Profit
∴ Sales = = ` 54,000 / 0.20 = ` 2,70,000
Gross Profit Margin

Credit Sales to Total Sales = 80%

∴ Credit Sales = ` 2,70,000 × 0.80 = ` 2,16,000
Total Assets Turnover = 0.3 times
Sales 2,70,000
∴ Total Assets = = = ` 9,00,000
Total Assets Turnover 0.3
Sales – Gross Profit = COGS
∴ COGS = ` 2, 70,000 – 54,000 = ` 2,16,000
Inventory turnover = 4 times
SANJAY SARAF SIR 80
CA INTER FINANCIAL MANAGEMENT

COGS 2,16,000
Inventory = = = ` 54,000
Inventory turnover 4

Average Collection Period = 20 days

360
∴ Debtors turnover = = 360/20 = 18
Average Collection Period

Credit Sales 2,16,000

∴ Debtors = = = `12,000
Debtors turnover 18
Current ratio = 1.8
Debtors + Inventory + Cash (Current Assets)
1.8 =
Creditors (Current Liabilities)

1.8 Creditors = (` 12,000 + ` 54,000 + Cash)

1.8 Creditors = ` 66,000 + Cash ------------- (i)
Long-term Debt to Equity = 40%
Shareholders’ Funds (Equity) = ` 6, 00,000
∴ Long-term Debt = ` 6, 00,000 × 40% = ` 2, 40,000
Creditors = ` 9, 00,000 – (6, 00,000 + 2, 40,000) = ` 60,000
∴ Cash = (` 60,000×1.8) – ` 66,000 = ` 42,000 [From equation (i)]

Balance Sheet
Amount Amount
Liabilities Assets
(`) (`)
Creditors 60,000 Cash 42,000
Long-term debt 2,40,000 Debtors 12,000
Shareholders’ funds 6,00,000 Inventory 54,000
Fixed Assets
7,92,000
(Balancing figure)
9,00,000 9,00,000

Question 7

MNP Limited has made plans for the next year 2015 -16. It is estimated that the company
will employ total assets of ` 25,00,000; 30% of assets being financed by debt at an interest
cost of 9% p.a. The direct costs for the year are estimated at ` 15,00,000 and all
other operating expenses are estimated at ` 2,40,000. The sales revenue are estimated at `
22,50,000. Tax rate is assumed to be 40%.

SANJAY SARAF SIR 81

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Required to calculate:
i. Net profit margin (After tax);
ii. Return on Assets (After tax);
iii. Asset turnover; and
iv. Return on Equity.

Answer :

The net profit is calculated as follows:

`
Sales Revenue 22,50,000
Less: Direct Costs 15,00,000
Gross Profits 7,50,000
Less: Operating Expense 2,40,000
Earnings before Interest and tax( EBIT) 5,10,000
Less: Interest on debt [9% × 7,50,000 (i.e. 30 % of 25,00,000 )] 67,500
Earnings before Tax)(EBT) 4,42,500
Less: Taxes (@ 40%) 1,77,000
Profit after Tax (PAT) 2,65,500

i. Net Profit Margin (After Tax)

EBIT (1 - t) ` 5,10,000×(1-0.4)
Net Profit Margin =  100 = = 13.6%
Sales ` 22,50,000

ii. Return on Assets (ROA)( After tax)

EBIT (1-t)
ROA =
Total Assets
` 5, 10, 000  1  0.4  ` 3, 06, 000
= 
` 25, 00, 000 ` 25, 00, 000
= 0.1224 = 12.24%

iii. Asset Turnover

Sales ` 22,50,000
Asset Turnover = = = 0.9
Assets ` 25,00,000
Asset Turnover = 0.9

SANJAY SARAF SIR 82

CA INTER FINANCIAL MANAGEMENT

iv. Return on Equity (ROE)

PAT ` 2,65,500
ROE = = = 15.17%
Equity ` 17,50,000
ROE = 15.17%

Question 8

The following accounting information and financial ratios of M Limited relate to the year
ended 31st March, 2016 :
Inventory Turnover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4
Gross Profit Ratio 25%

Total sales ` 30,00,000; cash sales 25% of credit sales; cash purchases ` 2,30,000; working
capital ` 2,80,000; closing inventory is ` 80,000 more than opening inventory.
You are required to calculate:
i. Average Inventory
ii. Purchases
iii. Average Debtors
iv. Average Creditors
v. Average Payment Period
vi. Average Collection Period
vii. Current Assets
[Link] Liabilities.

Answer :

i. Computation of Average Inventory

Gross Profit = 25% of ` 30, 00,000 = ` 7,50,000
Cost of goods sold (COGS) = Sales - Gross Profit = ` 30,00,000 – ` 7,50,000
= ` 22,50,000
COGS
Inventory Turnover Ratio =
Average Inventory
` 22,50,000
6 =
Average inventory
Average inventory = ` 3,75,000

SANJAY SARAF SIR 83

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

ii. Computation of Purchases

Purchases = COGS + (Closing Stock – Opening Stock) = ` 22,50,000 + 80,000*
Purchases = ` 23,30,000
* Increase in Stock = Closing Stock – Opening Stock = ` 80,000

iii. Computation of Average Debtors

25
Let Credit Sales be ` 100, Cash sales =   100 ` 25
100
Total Sales = 100 + 25= ` 125
Total sales is ` 125 credit sales is ` 100
` 30,00,000 x 100
If total sales is ` 30,00,000, then credit sales is =
125
Credit Sales = ` 24,00,000
Cash Sales = (` 30,00,000 – ` 24,00,000) = ` 6,00,000
Net Credit Sales ` 24,00,000
Debtors Turnover Ratio = =8= =8
Average debtors Average debtors
` 24,00,000
Average Debtors =
8
Average Debtors = ` 3,00,000

iv. Computation of Average Creditors

Credit Purchases = Purchases – Cash Purchases
= ` 23,30,000 – ` 2,30,000 = ` 21,00,000

Credit Purchases
Creditors Turnover Ratio =
Average Creditors
21,00,000
10 =
Average Creditors
Average Creditors = ` 2,10,000

v. Computation of Average Payment Period

Average Creditors
Average Payment Period =
Average Daily Credit Purchases
2,10,000 ` 2, 10, 000
= 
Credit Purchases ` 21, 00, 000
365 365
` 2, 10, 000
=  365 * = 36.5 days
` 21, 00, 000

SANJAY SARAF SIR 84

CA INTER FINANCIAL MANAGEMENT

Alternatively

Average Payment Period = 365/Creditors Turnover Ratio

= 365*/10 = 36.5 days

vi. Computation of Average Collection Period

Average Debtors ` 3,00,000
Average Collection Period =  365 * =  365  45.625 days
Net Credit Sales ` 24,00,000

Alternatively
365* 365
Average collection period =   45.625 days
Debtors Turnover Ratio 8
* 1 year is taken as 365 days.

vii. Computation of Current Assets

Current Assets (CA)
Current Ratio =  2.4
Current Liabilities (CL)
2.4 Current Liabilities = Current Assets or CL = CA/2.4
Further, Working capital = Current Assets – Current liabilities
So, ` 2,80,000 = CA-CA/2.4
` 2,80,000 = 1.4 CA/2.4 Or, 1.4 CA = ` 16,72,000
CA = ` 4,80,000

viii. Computation of Current Liabilities

4,80,000
Current liabilities = ` 2,00,000
2.4

Question 9

The assets of SONA Ltd. consist of fixed assets and current assets, while its current
liabilities comprise bank credit in the ratio of 2 : 1. You are required to prepare the Balance
Sheet of the company as on 31st March 2016 with the help of following information:
Share Capital ` 5,75,000
Working Capital (CA-CL) ` 1,50,000
Gross Margin 25%
Inventory Turnover 5 times
Average Collection Period 1.5 months
Current Ratio 1.5:1
Quick Ratio 0.8:1
Reserves & Surplus to Bank & Cash 4 times
Assume 360 days in a year

SANJAY SARAF SIR 85

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Answer :

Working Notes:

1. Computation of Current Assets (CA) and Current Liabilities (CL)

Current Assets
Current Ratio =
Current Liabilities
CA 1.5
=
CL 1
∴ CA = 1.5 CL
CA - CL = ` 1,50,000
1.5 CL- CL = ` 1,50,000
0.5 CL = ` 1,50,000
1,50,000
CL = = ` 3,00,000
0.5
CA = 1.5  3,00,000 = ` 4,50,000

2. Computation of Bank Credit (BC) and Other Current Liabilities (OCL)

Bank Credit 2
=
Other CL 1
BC = 2 OCL
BC + OCL = CL
2 OCL + OCL = ` 3,00,000
3 OCL = ` 3,00,000
OCL = ` 1,00,000
Bank Credit = 2 × 1,00,000 = ` 2,00,000

3. Computation of Inventory
Quick Assets
Quick Ratio =
Current Liabilities
Current Assets - Inventories
=
Current Liabilities
` 4,50,000 - Inventories
0.8 =
` 3,00,000
0.8 × ` 3,00,000 = ` 4,50,000 – Inventories
Inventories = ` 4,50,000 – ` 2,40,000 = ` 2,10,000

SANJAY SARAF SIR 86

CA INTER FINANCIAL MANAGEMENT

4. Computation of Debtors
Inventory Turnover = 5 times
Cost of goods sold (COGS)
Average Inventory =
Inventory Turnover
COGS = ` 2,10,000 × 5 = ` 10,50,000
Average Collection Period (ACP) = 1.5 months = 45 days
360 360
Debtors Turnover =  8
ACP 45
Sales - COGS
Gross Margin =  100  25%
Sales
25×Sales
Sales-COGS =
100
Sales – 0.25 Sales = COGS
0.75 Sales = ` 10,50,000
` 10,50,000
Sales =  ` 14,00,000
0.75
Sales
Debtors =
Debtors Turnover
` 14,00,000
=  ` 1,75,000
8
5. Computation of Bank and Cash
Bank & Cash = CA - (Debtors + Inventory)
= `4,50,000 – (` 1,75,000 + 2,10,000)= ` 4,50,000 – 3,85,000 = ` 65,000

6. Computation of Reserves & Surplus

Reserves & Surplus
4
Bank & Cash
Reserves & Surplus = 4 × ` 65,000 = ` 2,60,000

Balance Sheet of SONA Ltd. as on March 31, 2016

Amount Amount
Liabilities Assets
(`) (`)
Share Capital 5,75,000 Fixed Assets 6,85,000
Reserves & Surplus 2,60,000 Current Assets:
Current Liabilities: Inventories 2,10,000
Bank Credit 2,00,000 Debtors 1,75,000
Other Current Liabilities 1,00,000 Bank & Cash 65,000
11,35,000 11,35,000

SANJAY SARAF SIR 87

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Question 10

NOOR Limited provides the following information for the year ending 31st March, 2014:
Equity Share Capital `25,00,000
Closing Stock ` 6,00,000
Stock Turnover Ratio 5 times
Gross Profit Ratio 25%
Net Profit / Sale 20%
Net Profit / Capital 1
4

You are required to prepare:

Trading and Profit & Loss Account for the year ending 31st March, 2014.

Answer :

Working Notes:

Net Profit 1
i. =
Capital 4
Net Profit 1
=
25,00,000 4
Net Profit = 6,25,000

Net Profit
ii. = 20%
Sales
6,25,000
Sale =  31,25,000
0.20

Gross Profit
iii. Gross Profit Ratio =  100
Sales
Gross Profit
25 =  100
31,25,000
31, 25, 000  25
Gross Profit =  7,81,250
100

COGS
iv. Stock Turnover =
Average Stock

SANJAY SARAF SIR 88

CA INTER FINANCIAL MANAGEMENT

 31,25,000 - 7,81,250 
5 = 
 Average Stock 
23, 43,750
Average Stock = = 4,68,750
5
Closing Stock + Opening Stock
v. Average Stock =
2
6,00,000 + Opening Stock
4,68,750 =
2
Opening Stock = 9,37,500 – 6,00,000 = 3,37,500

Trading A/c for the year ending 31st March, 2014

Amount Amount
(`) (`)
To Opening Stock 3,37,500 By Sales 31,25,000
To Purchases (Balancing figure) 26,06,250 By Closing Stock 6,00,000
To Gross Profit c/f to P&L A/c 7,81,250 -
37,25,000 37,25,000

Profit & Loss A/c for the year ending 31st March, 2014
Amount Amount
(`) (`)
To Miscellaneous Expenses By Gross Profit
1,56,250 7,81,250
(balancing figure) b/f from Trading A/c
To Net Profit 6,25,000
7,81,250 7,81,250

Source : ICAI, Compilation (Old) - (From Question No. 11 - 16 )

Question 11

From the information given below calculate the amount of Fixed assets and Proprietor’s
fund.
Ratio of fixed assets to proprietors fund = 0.75
Net Working Capital = ` 6,00,000

SANJAY SARAF SIR 89

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Answer :

Calculation of Fixed Assets and Proprietor’s Fund

Since Ratio of Fixed Assets to Proprietor’s Fund = 0.75
Therefore, Fixed Assets = 0.75 Proprietor’s Fund
Net Working Capital = 0.25 Proprietor’s Fund
6,00,000 = 0.25 Proprietor’s
Therefore, Proprietor’s Fund

= ` 24,00,000
Proprietor’s Fund = ` 24,00,000
Since, Fixed Assets = 0.75 Proprietor’s Fund
Therefore, Fixed Assets = 0.75 × 24,00,000
= 18,00,000
Fixed Assets = ` 18,00,000

Question 12

ABC Limited has an average cost of debt at 10 per cent and tax rate is 40 per cent.
The Financial leverage ratio for the company is 0.60. Calculate Return on Equity
(ROE) if its Return on Investment (ROI) is 20 per cent.

Answer :

ROE = [ROI + {(ROI – r)  D/E}] (1 – t)

= [0.20 + {(0.20 – 0.10)  0.60}] (1 – 0.40)
=[ 0.20 + 0.06]  0.60 = 0.1560
ROE = 15.60%

Question 13

The Sales Manager of AB Limited suggests that if credit period is given for 1.5 months
then sales may likely to increase by `1,20,000 per annum. Cost of sales amounted to 90% of
sales. The risk of non-payment is 5%. Income tax rate is 30%. The expected return on
investment is `3,375 (after tax). Should the company accept the suggestion of Sales
Manager?

SANJAY SARAF SIR 90

CA INTER FINANCIAL MANAGEMENT

Answer :

Profitability on additional sales:

`
Increase in sales 1,20,000
Less: Cost of sales (90% sales) 1,08,000
Less: Bad debt losses (5% of sales) 6,000
Net profit before tax 6,000
Less: Income tax (30%) 1,800
4,200

Advise: Net profit after tax `4,200 on additional sales is higher than expected return.
Hence, proposal should be accepted.

Question 14

The financial statements of a company contain the following information for the year
ending 31st March, 2011:

Particulars `
Cash 1,60,000
Sundry Debtors 4,00,000
Short-term Investment 3,20,000
Stock 21,60,000
Prepaid Expenses 10,000
Total Current Assets 30,50,000
Current Liabilities 10,00,000
10% Debentures 16,00,000
Equity Share Capital 20,00,000
Retained Earnings 8,00,000

Statement of Profit for the year ended 31st March, 2011 `

Sales (20% cash sales) 40,00,000
Less: Cost of goods sold 28,00,000
Profit before Interest & Tax 12,00,000
Less: Interest 1,60,000
Profit before tax 10,40,000
Less: Tax @ 30% 3,12,000
Profit After Tax 7,28,000

SANJAY SARAF SIR 91

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

You are required to calculate:

i. Quick Ratio
ii. Debt-equity Ratio
iii. Return on Capital Employed, and
iv. Average collection period (Assuming 360 days in a year).

Answer :

i. Quick Ratio
Quick Assets
Quick Ratio 
Current Liabilities
Quick Assets = Current Assets – Stock – Prepaid Expenses
= 30,50,000- 21,60,000-10,000
Quick Assets = 8,80,000
Quick Ratio = 8,80,000/10,00,000 = 0.88 :1

ii. Debt-equity Ratio

Long term debt
Debt-Equity Ratio 
Shareholders Funds
16,00,000
=  0.57 : 1
(20,00,000 + 8,00,000)

iii. Return on Capital Employed (ROCE)

[Note: ROCE can be computed alternatively taking Average total assets into
consideration (EBIT (1 – T)/Average Total Assets). The value of ROCE would
then change accordingly as 15.56%]

iv. Average Collection Period

Sundry Debtors
= × 360
Credit Sales
4,00,000
=  360 = 45 days
32,00,000

SANJAY SARAF SIR 92

CA INTER FINANCIAL MANAGEMENT

Question 15

The following information relates to Beta Ltd. for the year ended 31st March 2013:
Net Working Capital ` 12,00,000
Fixed Assets to Proprietor’s Fund Ratio 0.75
Working Capital Turnover Ratio 5 Times
Return on Equity (ROE) 15%
There is no debt capital.

You are required to calculate:

i. Proprietor's Fund
ii. Fixed Assets
iii. Net Profit Ratio.

Answer :

i. Calculation of Proprietor’s Fund

Since Ratio of Fixed Assets to Proprietor’s Fund = 0.75
Therefore, Fixed Assets = 0.75 Proprietor’s Fund
Net Working Capital = 0.25 Proprietor’s Fund
12,00,000 = 0.25 Proprietor’s Fund
12,00,000
Therefore, Proprietors Fund =  48,00,000
0.25

ii. Calculation of Fixed Assets

Fixed Assets = 0.75 Proprietor’s Fund
= 0.75  48,00,000 = 36,00,000

iii. Calculation of Net Profit Ratio

Net Working Capital = 0.25  48,00,000 = 12,00,000
Sales
Working Capital Turnover Ratio =
Working Capital
∴ Sales = 60,00,000
PAT
ROE =
Equity
PAT
0.15 =
48,00,000
PAT = 7,20,000

SANJAY SARAF SIR 93

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Net Profit
Net Profit Ratio =  100
Sales

Net Profit Ratio = 12%

[Note : Fixed Assets may be computed alternatively by (Net Working Capital × Fixed
Assets to Proprietor’s Fund Ratio) and Proprietor’s Fund by (Fixed Assets + Net Working
Capital)].

Question 16

From the following information, prepare Balance Sheet of a firm:

Stock Turnover Ratio (based on cost of goods sold) 7 times
Rate of Gross Profit to Sales 25%
Sales to Fixed Assets 2 times
Average debt collection period 1.5 months
Current Ratio 2
Liquidity Ratio 1.25
Net Working Capital `8,00,000
Net Worth to Fixed Assets 0.9 times
Reserve and Surplus to Capital 0.25 times
Long Term Debt's Nil

All Sales are on credit basis.

Answer :

Working Notes;

1. Net Working Capital = Current Assets – Current Liabilities

=2-1=1
Net Working Capital × 2
Current Assets 
1
8,00,000 × 2
=
1
Current Assets =16,00,000
Current Liabilities = 16,00,000 – 8,00,000 = 8,00,000

SANJAY SARAF SIR 94

CA INTER FINANCIAL MANAGEMENT

Liquid Assets
2. Liquid Ratio 
Current Liabilities
Current Assets - Stock
1.25 
Current Liabilities
16,00,000 - Stock
1.25 
8,00,000
1.25  8,00,000 = 16,00,000 – Stock
10,00,000 = 16,00,000 – Stock
Stock = 6,00,000
Liquid Assets = 1.25  8,00,000 = 10,00,000

COGS
3. Stock Turnover Ratio =
Stock
COGS
7
6,00,000
COGS = 42,00,000

4. Sales – Gross Profit = COGS

Gross Profit
 25%
Sales
Gross Profit = 25% Sales
Sales – 25% Sales = COGS

12
5. Debtors turnover Ratio = 8
1.5
Credit Sales
Debtors =
Debtors Turnover
56,00,000
=  7,00,000
8
Sales
6. 2
Fixed Assets
56,00,000
Fixed Assets   28,00,000
2

7. Net worth = Fixed Assets + Current Assets – Long-term Debt – Current Liabilities
= 28,00,000 + 16,00,000 – 0 – 8,00,000
= 36,00,000

SANJAY SARAF SIR 95

 FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Reserves & Surplus

8.  0.25
Capital
Net worth = Reserves and Surplus + Capital
36,00,000
Capital   28,80,000
1.25
Reserves and Surplus = 0.25  28,80,000 = 7,20,000

9. Cash = Liquid Assets – Debtors

= 10,00,000 – 7,00,000 = 3,00,000

10. Long Term Debts = Nil

Draft Balance Sheet

Liabilities ` Assets `
Share Capital 28,80,000 Fixed Assets 28,00,000
Reserves and Surplus 7,20,000 Current Assets:
Long Term Debts - Stock 6,00,000
Current Liabilities 8,00,000 Debtors 7,00,000
Cash 3,00,000
44,00,000 44,00,000

(Note: The above solution has been worked out by ignoring the Net worth to Fixed
assets ratio given in the question in order to match the total of assets and liabilities in the
Balance Sheet).

SANJAY SARAF SIR 96

CA INTER FINANCIAL MANAGEMENT

 OTHER PROBLEMS

Question 1

Following information relate to a concern:

Debtors Velocity 3 months
Credits Velocity 2 months
Stock Turnover Ratio 1.5
Gross Profit Ratio 25%
Bills Receivables Rs. 25,000
Bills Payables Rs. 10,000
Gross Profit Rs. 4,00,000
Fixed Assets to turnover Ratio 4

Closing stock of the period is Rs. 10,000 above the opening stock.

Calculate
i. Sales and cost of goods sold
ii. Sundry Debtors
iii. Sundry Creditors
iv. Closing Stock
v. Fixed Assets
Source : ICAI, MTP II (New)
Answer :

i. Determination of Sales and Cost of goods sold:

Cost of Goods Sold = Sales – Gross Profit

= Rs. 16,00,000 - Rs. 4,00,000 = Rs. 12,00,000

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ii. Determination of Sundry Debtors:

Debtors velocity is 3 months or Debtors’ collection period is 3 months,
12 months
So, Debtors' turnover ratio = =4
3 months
Credit Sales
Debtors' turnover ratio =
Average Accounts Receivable
Rs.16,00,000
= =4
Bills Receivable + Sundry Debtors
Or, Sundry Debtors + Bills receivable = Rs. 4,00,000
Sundry Debtors = Rs. 4,00,000 – Rs. 25,000 = Rs. 3,75,000

iii. Determination of Sundry Creditors:

Creditors velocity of 2 months or credit payment period is 2 months.
12 months
So, Creditors’ turnover ratio = 6
2 months
Credit Purchases *
Creditors turnover ratio =
Average Accounts Payables
Rs.12,10,000
= 6
Sundry Creditors+ Bills Payables
So, Sundry Creditors + Bills Payable = Rs. 2,01,667
Or, Sundry Creditors + Rs. 10,000 = Rs. 2,01,667
Or, Sundry Creditors = Rs. 2,01,667 – Rs. 10,000 = Rs. 1,91,667

iv. Closing Stock

Cost of Goods Sold Rs.12,00,000
Stock Turnover Ratio =   1.5
Average Stock Average Stock
So, Average Stock = Rs. 8,00,000
Opening Stock + Closing Stock
Now Average Stock =
2
Opening Stock + (Opening Stock + Rs.10,000)
or,  Rs. 8,00,000
2
Or, Opening Stock = Rs. 7,95,000
So, Closing Stock= Rs. 7,95,000 + Rs. 10,000 = Rs. 8,05,000

v. Calculation of Fixed Assets

Cost of Goods Sold
Fixed Assets Turnover Ratio = 4
Fixed Assets
Rs.12,00,000
Or, 4
Fixed Assets
Or, Fixed Asset = Rs. 3,00,000
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Workings:

*Calculation of Credit purchases:

Cost of goods sold = Opening stock + Purchases – Closing stock
Rs. 12,00,000 = Rs. 7,95,000 + Purchases – Rs. 8,05,000
Rs. 12,00,000 + Rs. 10,000 = Purchases
Rs. 12,10,000 = Purchases (credit).

Assumption:

i. All sales are credit sales

ii. All purchases are credit purchase
iii. Stock Turnover Ratio and Fixed Asset Turnover Ratio may be calculated either on Sales
or on Cost of Goods Sold.

Question 2

The accountant of Moon Ltd. has reported the following data:

Gross profit ` 60,000
Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days

Assume 360 days in a year

You are required to complete the following:

Balance Sheet of Moon Ltd.

Liabilities ` Assets `
Net Worth - Fixed Assets -
Current Liabilities - Stock -
Debtors -
Cash -
Total liabilities - Total Assets -
Source : ICAI, May 2018 Question Paper

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Answer :

Preparation of Balance Sheet

Working Notes:
Sales = Gross Profit / Gross Profit Margin
= 60,000 / 0.2 = ` 3,00,000
Total Assets = Sales / Total Asset Turnover
= 3,00,000 / 0.3 = ` 10,00,000
Net Worth = 0.9  Total Assets
= 0.9  ` 10,00,000 = ` 9,00,000
Current Liability = Total Assets – Net Worth
= ` 10,00,000 – ` 9,00,000
= ` 1,00,000
Current Assets = 1.5  Current Liability
= 1.5  ` 1,00,000 = ` 1,50,000
Stock = Current Assets – Liquid Assets
= Current Assets – (Liquid Assets / Current Liabilities =1)
= 1,50,000 – (LA / 1,00,000 = 1) = ` 50,000
Debtors = Average Collection Period  Credit Sales / 360
= 60  0.8  3,00,000 / 360 = ` 40,000
Cash = Current Assets – Debtors – Stock
= ` 1,50,000 – ` 40,000 – ` 50,000
=` 60,000
Fixed Assets = Total Assets – Current Assets
= ` 10,00,000 – ` 1,50,000
= ` 8,50,000

Balance Sheet
Liabilities ` Assets `
Net Worth 9,00,000 Fixed Assets 8,50,000
Current Liabilities 1,00,000 Stock 50,000
Debtors 40,000
Cash 60,000
Total liabilities 10,00,000 Total Assets 10,00,000

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Question 3

Following figures are available in the books Tirupati Ltd.

Fixed assets turnover ratio 8 times
Capital turnover ratio 2 times
Inventory Turnover 8 times
Receivable turnover 4 times
Payable turnover 6 times
G P Ratio 25%

Gross profit during the year amounts to ` 8,00,000. There is no long-term loan or overdraft.
Reserve and surplus amount to ` 2,00,000. Ending inventory of the year is ` 20,000
above the beginning inventory.

Required:
Calculate various assets and liabilities and prepare a Balance sheet of Tirupati Ltd.
Source : ICAI, RTP May 2018 (New)
Answer :

Gross Profit
a. G.P. ratio =  25%
Sales

b. Cost of Sales = Sales – Gross profit

= ` 32,00,000 - ` 8,00,000
= ` 24,00,000

Sales
c. Receivable turnover  4
Receivables

Cost of Sales
d. Fixed assets turnover  8
Fixed Assets

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Cost of Sales
e. Inventory turnover  8
Average Stock
Cost of Sales ` 24,00,000
Average Stock    = ` 3,00,000
8 8
Opening Stock + Closing Stock
Average Stock 
2
Opening Stock + Opening Stock + 20,000
Average Stock 
2
Average Stock = Opening Stock + ` 10,000
Opening Stock = Average Stock - ` 10,000
= ` 3,00,000 - `10,000
= ` 2,90,000
Closing Stock = Opening Stock + ` 20,000
= ` 2,90,000 + ` 20,000
= ` 3,10,000

Purchases
f. Payable turnover  6
Payables
Purchases = Cost of Sales + Increase in Stock
= ` 24,00,000 + ` 20,000
= ` 24,20,000
Purchase ` 24,20,000
Payables = =  ` 4,03,333
6 6

Cost of Sales
g. Capital turnover  2
Capital Employed
Cost of Sales ` 24,00,000
Capital Employed =   ` 12,00,000
2 2

h. Share Capital = Capital Employed – Reserves & Surplus

= ` 12,00,000 – ` 2,00,000 = ` 10,00,000
Balance Sheet of Tirupati Ltd as on……………
Liabilities ` Assets `
Share Capital 10,00,000 Fixed Assets 3,00,000
Reserve & Surplus 2,00,000 Closing Inventories 3,10,000
Payables 4,03,333 Receivables 8,00,000
16,03,333 Other Current Assets 1,93,333
16,03,333 16,03,333
(Fixed Asset turnover, inventory turnover capital turnover is calculated on cost of
sales)

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Question 4

Assuming the current ratio of a Company is 2, STATE in each of the following

cases whether the ratio will improve or decline or will have no change:
i. Payment of current liability
ii. Purchase of fixed assets by cash
iii. Cash collected from Customers
iv. Bills receivable dishonoured
v. Issue of new shares
Source : ICAI, RTP November 2018 (New)
Answer :

Current Assets (CA)

Current Ratio  = 2 i.e. 2 : 1
Current Liabilities (CL)

S. Situation Improve/ Decline/ Reason

No. No change
i Payment of Current Ratio Let us assume CA is ` 2 lakhs & CL is ` 1
Current will improve lakh. If payment of Current Liability = `10,000
liability then, CA = 1, 90,000 CL = 90,000.

= 2.11 : 1. When Current Ratio is 2:1 Payment

of Current liability will reduce the same
amount in the numerator and denominator.
Hence, the ratio will improve.

ii Purchase of Current Ratio Since the cash being a current asset

Fixed Assets will decline converted into fixed asset, current assets
by cash reduced, thus current ratio will fall.
iii Cash Current Ratio Cash will increase and Debtors will reduce.
collected will not change Hence No Change in Current Asset.
from
Customers
iv Bills Current Ratio Bills Receivable will come down and
Receivable will not change debtors will increase. Hence no change in
dishonoured Current Assets.
v Issue of Current Ratio As Cash will increase, Current Assets will
New Shares will improve increase and current ratio will increase.

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Question 5

The summarized Balance Sheet of TPA Traders Ltd. for the year ended 31-03-2018 is given
below:
Capital and Liabilities ` Assets `
Equity Share capital (fully paid-up) 1,400 Fixed Asset (at cost) 2,100
Less: Depreciation 250 1,850
Reserves and surplus 450 Current assets:
Retained earnings 200 Stock 250
Provision for taxation 100 Receivables 300
Sundry payables 400 Cash & Bank 150 700
2,550 2,550

The following further particulars are also given for the year
(in lakhs of rupee)
Sales 1,200
Earnings before interest and tax (EBIT) 300
Net profit after tax (PAT) 200

Calculate the following for the company and explain the significance of each in one
or two sentences.
i. Current ratio
ii. Liquidity ratio
iii. Profitability ratio
iv. Profitability on fund employed
v. Receivables’ (Debtor’s) Turnover ratio
vi. Average receivable (debtor’s) collection period
vii. Stock Turnover ratio
[Link] on Equity
Source : ICAI, MTP I (Old)
Answer :

Current assets Stock + Receivables + Cash

i. Current Ratio  
Current liablities S. Payables + Provision for taxation

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Liquid assets Current assets - Stock

ii. Liquidity Ratio = 
Current liabilities Current liabilities

iii. Profitability ratio

iv. Profitability on Funds Employed

Sales 1,200
v. Receivables’ (Debtors’) turnover ratio =   4 times
Average receivables 300

vi. Average Receivables’ (Debtors’) Collection Period

Sales 1, 200
[Link] turnover ratio =   4.8 times
Average Stock 250

Profit after tax

viii. Return on Equity =  100
Shareholders' funds

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Question 6

The following information was taken from the financial statements of Gamma
Limited (amount in thousands of rupees).
Particulars Year 1 Year 2 Year 3
Total Assets 750 850 860
Credit Sales 420 520 550
Cost of goods sold 450 595 645
Cash 50 60 55
Debtors 150 165 180
Inventory 130 160 170
Net Fixed Assets 120 250 250
Creditors 75 85 100
Short term debt 125 175 170
Long-term Debt 125 185 175
Equity 200 210 -

You are required to calculate those ratios which indicate the efficient use of assets and
discuss potential sources of trouble.
Source : ICAI,RTP November 2013 (Old)
Answer :

The efficient use of assets is indicated by the following key ratios: (a) Current assets
turnover, (b) Debtors' turnover, (c) Inventory turnover, (d) Fixed assets turnover, and (e)
Total assets turnover.
Computation of Ratios:
Year 1 Year 2 Year 3
a. Computation of Ratios: 1.36 1.55
(Cost of goods sold / Total current assets) 1.59
b. Debtor's turnover 2.8* 3.30 3.19
(Credit sales / Average debtors)
c. Inventory turnover 3.46* 4.10 3.91
(Cost of goods sold/ Average inventory)
d. Fixed assets turnover 3.75 2.38 2.58
(Cost of goods sold/ Fixed Assets)
e. Total assets turnover 1.00 0.93 0.98
(Cost of goods sold/ Total assets)

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* Based on Debtors and Inventory at the end, as their opening balances are not
available.

Comments : The first three ratios indicate the efficiency of Current Assets usage, and the
latter two, namely, Fixed assets turnover and Total assets turnover ratio, show the
efficiency of utilisation of these. Current assets utilisation appears to be very satisfactory as
reflected in the first three types of ratios. No major change is noticeable in their values over
a period of time, which is presumably indicative of consistency in Debtors collection period
and inventory turnover. There does not seem to be any significant problem regarding
utilisation of Current assets.

However, it appears that fixed assets are not being fully utilised. Investments in
fixed assets have more than doubled during years 2 and 3. The Fixed assets turnover
ratio has sharply fallen to 2.58 in year 3 from 3.75 in year 1. Thus, investment in fixed assets
are either excessive, or the capacity of the additional plant is under utilised. This is
corroborated by the fact that sales in the latter 2-year have increased by around
15%. Therefore, the remedy lies in utilising the plant capacity by increasing
production and sales.

Question 7

You have been hired as an analyst for the Bank of Delhi and your team is working on an
independent assessment of Meyland Limited. Meyland Limited specializes in the
production of freshly imported cheese from Switzerland. Your colleague has provided
you with the following data for your reference:
Ratios 2014 2013 2012 2014
Industry
Average
Long-term Debt 0.45 0.40 0.35 0.35
Inventory Turnover 62.65 42.42 32.25 53.25
Depreciation/Total Assets 0.25 0.014 0.018 0.015
Days’ Sales in Receivables 113 98 94 130.25
Debt to Equity 0.75 0.85 0.90 0.88
Profit Margin 0.082 0.07 0.06 0.075
Total Asset Turnover 0.54 0.65 0.70 0.40
Quick Ratio 1.028 1.03 1.029 1.031
Current Ratio 1.33 1.21 1.15 1.25
Times Interest Earned 0.9 4.375 4.45 4.65
Equity Multiplier 1.75 1.85 1.90 1.88
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a. In the annual report to the shareholders, the CEO of Meyland Limited wrote, “2012 was
a good year for the company with respect to our ability to meet our short-term
obligations. We had higher liquidity largely due to an increase in highly liquid
current assets (cash, account receivables and short-term marketable securities).” Is the
CEO correct? Explain and use only relevant information in your analysis.
b. What can you say about Meyland Limited's asset management? Be as complete as
possible given the above information, but do not use any irrelevant information.
c. You are asked to provide the shareholders with an assessment of Meyland
Limited's solvency and leverage. Be as complete as possible given the above
information, but do not use any irrelevant information.
Source : ICAI,RTP November 2014 (Old)
Answer :

a. The answer should be focused on using the current and quick ratios. While the
current ratio has steadily increased, it is to be noted that the liquidity has not
resulted from the most liquid assets as the CEO proposes. Instead, from the quick ratio,
it is noted that the increase in liquidity is caused by an increase in inventories. For a
fresh cheese company, it can be argued that inventories are relatively liquid when
compared to other industries. Also, given the information, the industry-
benchmark can be used to derive that the company's quick ratio is very similar
to the industry level and that the current ratio is indeed slightly higher - again,
this seems to come from inventories.

b. Inventory turnover, day’s sales in receivables, and the total asset turnover ratio are to be
mentioned here. Inventory turnover has increased over time and is now above the
industry average. This is good - especially given the fresh cheese nature of the
company’s industry. In 2014, it means for example that every 365/62.65 = 5.9 days the
company is able to sell its inventories as opposed to the industry average of 6.9 days.
Days' sales in receivables have gone down over time, but are still better than the
industry average. So, while they are able to turn inventories around quickly, they seem
to have more trouble collecting on these sales, although they are doing better than the
industry. Finally, total asset turnover is gone down over time, but it is still higher than
the industry average. It does tell us something about a potential problem in the
company's long term investments, but again, they are still doing better than the
industry.

c. Solvency and leverage is captured by an analysis of the capital structure of the

company and the company's ability to pay interest. Capital structure: Both the equity
multiplier and the debt-to-equity ratio tell us that the company has become less
levered. To get a better idea about the proportion of debt in the firm, we can turn the
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D/E ratio into the D/V ratio: 2014: 43%, 2013: 46%, 2012:47%, and the industry-
average is 47%. So based on this, we would like to know why this is happening and
whether this is good or bad. From the numbers it is hard to give a qualitative
judgment beyond observing the drop in leverage. In terms of the company's ability to
pay interest, 2014 looks pretty bad. However, remember that times interest earned
uses EBIT as a proxy for the ability to pay for interest, while we know that we should
probably consider cash flow instead of earnings. Based on a relatively large
amount of depreciation in 2014 (see info), it seems that the company is doing just fine.

Question 8

From the following table of financial ratios of R. Textiles Limited, comment on various
ratios given at the end:
Ratios 2016 2017 Average of Textile
Industry
Liquidity Ratios
Current ratio 2.2 2.5 2.5
Quick ratio 1.5 2 1.5
Receivable turnover ratio 6 6 6
Inventory turnover 9 10 6
Receivables collection period 87 days 86 days 85 days
Operating profitability
Operating income -ROI 25% 22% 15%
Operating profit margin 19% 19% 10%
Financing decisions
Debt ratio 49.00% 48.00% 57%
Return
Return on equity 24% 25% 15%

Comment on the following aspect of R. Textiles Limited

i. Liquidity
ii. Operating profits
iii. Financing
iv. Return to the shareholders
Source : ICAI,RTP November 2017 (Old)

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Answer :

Ratios Comment
Liquidity It is reasonably good. All the liquidity ratios are either better or same
in both the year compare to the Industry Average. Receivable
turnover and collection period is also good.
Operating Profits Operating Income-ROI and Operating Profit Margin is favorable
compare to the Industry average. Operating Income-ROI is stable
also.
Financing More than 50% of financing is being done with shareholders’
funds. It also signifies that dependency on debt compared to other
industry players (57%) is low.
Return to the R’s ROE is 24 per cent in 2016 and 25 per cent in 2017 compared to an
shareholders industry average of 15 per cent. The ROE is stable and improved over
the last year

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 THEORETICAL QUESTIONS

Source : ICAI, Compilation (Old) - (From Question No. 1 - 12 )

Question 1

Discuss any three ratios computed for investment analysis.

Answer :

Three ratios computed for investment analysis are as follows;

Profit after tax
i. Earnings per share =
Number of equity shares outstanding
Equity dividend per share  100
ii. Dividend yield ratio =
Market price per share
Net profit before interest and tax  100
iii. Return on capital employed =
Capital employed

Question 2

Discuss the financial ratios for evaluating company performance on operating

efficiency and liquidity position aspects.

Answer :

Financial ratios for evaluating performance on operational efficiency and liquidity

position aspects are discussed as:

Operating Efficiency : Ratio analysis throws light on the degree of efficiency in the
management and utilization of its assets. The various activity ratios (such as turnover
ratios) measure this kind of operational efficiency. These ratios are employed to evaluate
the efficiency with which the firm manages and utilises its assets. These ratios usually
indicate the frequency of sales with respect to its assets. These assets may be capital assets
or working capital or average inventory. In fact, the solvency of a firm is, in the ultimate
analysis, dependent upon the sales revenues generated by use of its assets – total as well as
its components.

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Liquidity Position : With the help of ratio analysis, one can draw conclusions regarding
liquidity position of a firm. The liquidity position of a firm would be satisfactory, if it is
able to meet its current obligations when they become due. Inability to pay-off short-
term liabilities affects its credibility as well as its credit rating. Continuous default on the
part of the business leads to commercial bankruptcy. Eventually such commercial
bankruptcy may lead to its sickness and dissolution. Liquidity ratios are current ratio,
liquid ratio and cash to current liability ratio. These ratios are particularly useful in
credit analysis by banks and other suppliers of short-term loans.

Question 3

Explain the need of debt-service coverage ratio.

Answer :

Debt Service Coverage Ratio: Lenders are interested in this ratio to judge the firm’s ability
to pay off current interest and installments.
Earnings available for debt service
Debt service coverage ratio =
Interest Instalment

Where,
Earning for debt service = Net profit
+ Non-cash operating expenses like depreciation and other
amortizations
+ Non-operating adjustments like loss on sale of
+ Fixed Assets + Interest on Debt Fund

Question 4

Diagrammatically present the DU PONT CHART to calculate return on equity.

Answer :

Du Pont Chart
There are three components in the calculation of return on equity using the traditional
DuPont model- the net profit margin, asset turnover, and the equity multiplier. By
examining each input individually, the sources of a company's return on equity can be
discovered and compared to its competitors.
Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier)

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Question 5

How return on capital employed is calculated? What is its significance?

Answer :

Return on Capital Employed (ROCE) : It is the most important ratio of all. It is the
percentage of return on funds invested in the business by its owners. In short, it
indicates what returns management has made on the resources made available to
them before making any distribution of those returns.

EBIT
Return on Capital Employed =  100
Capital Employed
Where,
Capital Employed = Equity Share Capital
+ Reserve and Surplus
+ Pref. Share Capital
+ Debentures and other long term loan
– Misc. expenditure and losses
– Non-trade Investments.
Intangible assets (assets which have no physical existence like goodwill, patents and
trademarks) should be included in the capital employed. But no fictitious asset should be
included within capital employed.

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Question 6

What is quick ratio? What does it signify?

Answer :

Quick Ratio : It is a much more exacting measure than the current ratio. It adjusts the
current ratio to eliminate all assets that are not already in cash (or near cash form). A ratio
less than one indicates low liquidity and hence is a danger sign.
Quick Assets
Quick Ratio 
Current Liabilities

Where,
Quick Assets = Current Assets – Inventory

Question 7

What do you mean by Stock Turnover ratio and Gearing ratio?

Answer :

Stock Turnover Ratio and Gearing Ratio

Stock Turnover Ratio helps to find out if there is too much inventory build-up. An
increasing stock turnover figure or one which is much larger than the "average" for
an industry may indicate poor stock management. The formula for the Stock Turnover
Ratio is as follows:
Cost of Sales Turnover
Stock Turnover ratio= or
Average inventory Average inventory

Gearing Ratio indicates how much of the business is funded by borrowing. In theory, the
higher the level of borrowing (gearing), the higher are the risks to a business, since
the payment of interest and repayment of debts are not "optional" in the same way
as dividends. However, gearing can be a financially sound part of a business's
capital structure particularly if the business has strong, predictable cash flows. The
formula for the Gearing Ratio is as follows:

Borrowings (all long term debts including normal overdraft)

Gearing Ratio =
Net Assets or Shareholders' funds

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Question 8

How is Debt service coverage ratio calculated? What is its significance?

Answer :

Calculation of Debt Service Coverage Ratio (DSCR) and its Significance

The debt service coverage ratio can be calculated as under:

Earnings available for debt service
Debt Service Coverage Ratio 
Interest + Installments
EBITDA
Or, Debt Service Coverage Ratio =
Principal Repayment Due
Interest 
1 - Tc
Debt service coverage ratio indicates the capacity of a firm to service a particular level of
debt i.e. repayment of principal and interest. High credit rating firms target DSCR to be
greater than 2 in its entire loan life. High DSCR facilitates the firm to borrow at the most
competitive rates.

Question 9

Discuss the composition of Return on Equity (ROE) using the DuPont model.

Answer :

Composition of Return on Equity using the DuPont Model

There are three components in the calculation of return on equity using the traditional
DuPont model- the net profit margin, asset turnover, and the equity multiplier. By
examining each input individually, the sources of a company's return on equity can be
discovered and compared to its competitors.
a. Net Profit Margin : The net profit margin is simply the after-tax profit a
company generates for each rupee of revenue.
Net profit margin = Net Income ÷ Revenue
Net profit margin is a safety cushion; the lower the margin, lesser the room for error.

b. Asset Turnover : The asset turnover ratio is a measure of how effectively a

company converts its assets into sales. It is calculated as follows:
Asset Turnover = Revenue ÷ Assets

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The asset turnover ratio tends to be inversely related to the net profit margin;
i.e., the higher the net profit margin, the lower the asset turnover.

c. Equity Multiplier : It is possible for a company with terrible sales and margins to take
on excessive debt and artificially increase its return on equity. The equity
multiplier, a measure of financial leverage, allows the investor to see what portion
of the return on equity is the result of debt. The equity multiplier is calculated as
follows:
Equity Multiplier = Assets ÷ Shareholders’ Equity.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three
components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = Net profit margin× Asset turnover × Equity multiplier

Question 10

Explain briefly the limitations of Financial ratios.

Answer :

Limitations of Financial Ratios

The limitations of financial ratios are listed below:

a. Diversified product lines : Many businesses operate a large number of divisions in
quite different industries. In such cases, ratios calculated on the basis of aggregate
data cannot be used for inter-firm comparisons.
b. Financial data are badly distorted by inflation : Historical cost values may be
substantially different from true values. Such distortions of financial data are also
carried in the financial ratios.
c. Seasonal factors may also influence financial data.
d. To give a good shape to the popularly used financial ratios (like current ratio, debt-
equity ratios, etc.): The business may make some year-end adjustments. Such window
dressing can change the character of financial ratios which would be different had there
been no such change.
e. Differences in accounting policies and accounting period : It can make the
accounting data of two firms non-comparable as also the accounting ratios.
f. There is no standard set of ratios against which a firm’s ratios can be
compared : Sometimes a firm’s ratios are compared with the industry average. But if a
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firm desires to be above the average, then industry average becomes a low
standard. On the other hand, for a below average firm, industry averages become
too high a standard to achieve.

Question 11

Explain the following ratios:

i. Operating ratio
ii. Price earnings ratio

Answer :

i. Concept of Operating Ratio

Cost of goods sold + operating expenses
Operating ratio=  100
Net sales
This is the test of the operational efficiency with which the business is being carried; the
operating ratio should be low enough to leave a portion of sales to give a fair return to
the investors.

ii. Concept of Price-Earnings ratio

Market price per equity share
Price Earnings Ratio =
Earning per share
This ratio indicates the number of times the earnings per share is covered by its market
price. It indicates the expectation of equity investors about the earnings of the firm.

Question 12

Explain the important ratios that would be used in each of the following situations:
i. A bank is approached by a company for a loan of ` 50 lakhs for working
capital purposes.
ii. A long term creditor interested in determining whether his claim is adequately
secured.
iii. A shareholder who is examining his portfolio and who is to decide whether he
should hold or sell his holding in the company.
iv. A finance manager interested to know the effectiveness with which a firm uses
its available resources.

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Answer :

Important Ratios used in different situations

i. Liquidity Ratios : Here Liquidity or short-term solvency ratios would be used by the
bank to check the ability of the company to pay its short-term liabilities. A bank
may use Current ratio and Quick ratio to judge short terms solvency of the firm.

ii. Capital Structure/Leverage Ratios : Here the long-term creditor would use the
capital structure/leverage ratios to ensure the long term stability and structure of the
firm. A long term creditors interested in the determining whether his claim is
adequately secured may use Debt-service coverage and interest coverage ratio.

iii. Profitability Ratios : The shareholder would use the profitability ratios to
measure the profitability or the operational efficiency of the firm to see the final
results of business operations. A shareholder may use return on equity, earning per
share and dividend per share.

iv. Activity Ratios : The finance manager would use these ratios to evaluate the
efficiency with which the firm manages and utilises its assets. Some important ratios are
(a) Capital turnover ratio (b) Current and fixed assets turnover ratio (c) Stock, Debtors
and Creditors turnover ratio.

Question 13

Comment on the Debt Service Coverage Ratio.

Source : ICAI, Compilation (Old)
Answer :

Comment on Debt Service Coverage Ratio (DSCR)

Debt service coverage ratio indicates the capacity of a firm to service a particular level of
debt i.e. repayment of principal and interest. High credit rating firms target DSCR to be
greater than 2 in its entire loan life. High DSCR facilitates the firm to borrow at the most
competitive rates. Lenders are interested in this ratio to judge the firm’s ability to
pay off current interest and installments.
The debt service coverage ratio can be calculated as under:
Earnings available for debt service
Debt Service Coverage Ratio 
Interest + Installments
EBITDA
Or, Debt Service Coverage Ratio =
Principal Repayment Due
Interest 
1 - Tc

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COST OF CAPITAL
4

LEARNING OUTCOMES
 Discuss the need and sources of finance to a business entity.
 Discuss the meaning of cost of capital for raising capital from different sources
of finance.
 Measure cost of individual components of capital
 Calculate weighted cost of capital and marginal cost of capital, Effective Interest
rate.

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CHAPTER OVERVIEW

COST OF CAPITAL

Cost of Cost of Cost of Combination of

Cost of Debt Preference Retained Cost and
Equity Weight of each
Share Earning sources of
Capital

Weighted
Average Cost
of Capital
(WACC)

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EXAMPLES

Source : ICAI, SM (New) - ( Example 1 & 2)

Example 1

A company issued 10,000, 10% debentures of ` 100 each on 1.4.2013 to be matured on

1.4.2018. The company wants to know the current cost of its existing debt and the market
price of the debentures is ` 80. Compute the cost of existing debentures assuming 35% tax
rate.

Step-1: Identification of relevant cash flows

Year Cash flows
0 Current market price (P0) = `80
1 to 5 Interest net of tax [I(1-t)] = 10% of `100 (1-0.35) = `6.5
5 Redemption value (RV) = Face value i.e. `100

Step - 2 : Calculation of NPVs at two discount rates

Year Cash flows Discount Present Discount Present
factor @ 10% Value factor @ 15% Value
0 80 1.000 (80.00) 1.000 (80.00)
1 to 5 6.5 3.791 24.64 3.352 21.79
5 100 0.621 62.10 0.497 49.70
NPV +6.74 -8.51

Step- 3: Calculation of IRR

NPVL 6.74
IRR = L   H  L  = 10%   15%  10%  12.21%
NPVL -NPVH 6.74   8.51 
YTM or present value method is a superior method of determining cost of debt
company to approximation method and it is also preferred in the field of finance.

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 COST OF CAPITAL

Example 2

A company issued 10,000, 15% Convertible debentures of `100 each with a maturity period
of 5 years. At maturity the debenture holders will have the option to convert the debentures
into equity shares of the company in the ratio of 1:10 (10 shares for each debenture). The
current market price of the equity shares is `12 each and historically the growth rate of the
shares are 5% per annum. Compute the cost of debentures assuming 35% tax rate.

Determination of Redemption value:

Higher of
i. The cash value of debentures = `100
ii. Value of equity shares = 10 shares × `12(1+0.05)5
= 10 shares × 15.312 = `153.12
`153.12 will be taken as redemption value as it is higher than the cash option
and attractive to the investors.
Calculation of Cost of Convertible debenture (using approximation method):

I 1  t 
 RV  NP  15  1  0.35  
 153.12  100 
n 5 9.75  10.62
kd  =   16.09%
 RV  NP   153.12  100  126.53
2 2

Alternatively:

Using present value method

Year Cash flows Discount Present Discount Present
factor @ 15% Value factor @ 20% Value
0 100 1.000 (100.00) 1.000 (100.00)
1 to 5 9.75 3.352 32.68 2.991 29.16
5 153.12 0.497 76.10 0.402 61.55
NPV +8.78 -9.29

NPVL 8.78
IRR = L   H  L  = 15%   20%  15%  0.17429 or 17.43%
NPVL -NPVH 8.78   9.29 

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SUMMARY

 Cost of Capital: In simple terms Cost of capital refers to the discount rate that is
used in determining the present value of the estimated future cash proceeds of the
business/new project and eventually deciding whether the business/new project is
worth undertaking or now. It is also the minimum rate of return that a firm must
earn on its investment which will maintain the market value of share at its current
level. It can also be stated as the opportunity cost of an investment, i.e. the rate of
return that a company would otherwise be able to earn at the same risk level as the
investment that has been selected.
 Components of Cost of Capital: In order to calculate the specific cost of each type of
capital, recognition should be given to the explicit and the implicit cost. The cost of
capital can be either explicit or implicit. The explicit cost of any source of capital may
be defined as the discount rate that equals that present value of the cash inflows that
are incremental to the taking of financing opportunity with the present value of its
incremental cash outflows. Implicit cost is the rate of return associated with the best
investment opportunity for the firm and its shareholders that will be foregone if the
project presently under consideration by the firm was accepted.
 Measurement of Specific Cost of Capital for each source of Capital: The first step
in the measurement of the cost of the capital of the firm is the calculation of the cost
of individual sources of raising funds. From the viewpoint of capital budgeting
decisions, the long term sources of funds are relevant as they constitute the major
sources of financing the fixed assets. In calculating the cost of capital, therefore the
focus on long-term funds and which are -
Long term debt (including Debentures)
Preference Shares
Equity Capital
Retained Earnings
 Weighted Average Cost Of Capital : WACC (weighted average cost of capital)
represents the investors’ opportunity cost of taking on the risk of putting money into
a company. Since every company has a capital structure i.e. what percentage of
funds comes from retained earnings, equity shares, preference shares, debt and
bonds, so by taking a weighted average, it can be seen how much cost/interest the
company has to pay for every rupee it borrows/invest. This is the weighted average
cost of capital.

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. Which of the following is not an assumption of the capital asset pricing model
(CAPM)?
a. The capital Market is efficient
b. Investors lend or borrow at a risk-free rate of return
c. Investors do not have the same expectations about the risk and return
d. Investor’s decisions are based on a single-time period

2. Given: risk-free rate of return = 5 % market return = 10%, cost of equity = 15% value of
beta (β) is:
a. 1.9
b. 1.8
c. 2.0
d. 2.2

3. Which of the following sources of funds is related to Implicit Cost of Capital?

a. Equity Share Capital,
b. Preference Share Capital,
c. Debentures,
d. Retained earnings.

4. Which of the following cost of capital require to adjust tax?

a. Cost of Equity Shares,
b. Cost of Preference Shares,
c. Cost of Debentures,
d. Cost of Retained Earnings.

5. Marginal Cost of capital is the cost of:

a. Additional Revenue,
b. Additional Funds,
c. Additional Interests,
d. None of the above.

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6. In order to calculate Weighted Average Cost of Capital, weights may be based on:
a. Market Values,
b. Target Values
c. Book Values,
d. Anyone.

7. Firm’s Cost of Capital is the average cost of :

a. All sources of finance,
b. All Borrowings,
c. All share capital,
d. All Bonds & Debentures.

ANSWERS

1. c 2. c

3. d 4. c
5. b 6. d
7. a

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 ILLUSTRATIONS

Source : ICAI, SM (New) - (From Question 1- 14)

Question 1

Five years ago, Sona Limited issued 12 per cent irredeemable debentures at ` 103, at
` 3 premium to their par value of ` 100. The current market price of these debentures
is ` 94. If the company pays corporate tax at a rate of 35 per cent what is its current cost of
debenture capital?

Answer :

Cost of irredeemable debenture:

I
kd  1  t
NP
` 12
Kd   1  0.35   0.08297 or 8.30%
` 94

Question 2

A company issued 10,000, 10% debentures of ` 100 each at a premium of 10% on

1.4.2017 to be matured on 1.4.2022. The debentures will be redeemed on maturity.
Compute the cost of debentures assuming 35% as tax rate.

Answer :

The cost of debenture (Kd) will be calculated as below:

I 1  t 
 RV  NP 
Cost of debenture (Kd) = k d  n
 RV  NP 
2
I = Interest on debenture = 10% of `100 = `10
NP = Net Proceeds = 110% of `100 = `110
RV = Redemption value = `100
n = Period of debenture = 5 years
t = Tax rate = 35% or 0.35

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` 10  1  0.35  
 ` 100  ` 110 
5 years
Kd 
 ` 100  ` 110 
2
` 10  0.65  ` 2 ` 4.5
Or, K d    0.0428 or 4.28%
` 105 ` 105

Question 3

A company issued 10,000, 10% debentures of ` 100 each on 1.4.2017 to be matured on

1.4.2022. The company wants to know the current cost of its existing debt and the market
price of the debentures is ` 80. Compute the cost of existing debentures assuming 35% tax
rate.

Answer :

I 1  t 
 RV  NP 
Cost of debenture (Kd) = k d  n
 RV  NP 
2
I = Interest on debenture = 10% of `100 = `10
NP = Current market price = `80
RV = Redemption value = `100
n = Period of debenture = 5 years
t = Tax rate = 35% or 0.35

` 10  1  0.35  
 ` 100  ` 80 
5 years
Kd 
 ` 100  ` 80 
2
` 10  0.65  ` 4 ` 10.5
Or, K d    0.1166 or 11.67%
` 90 ` 90

Question 4

RBML is proposing to sell a 5-year bond of ` 5,000 at 8 per cent rate of interest
per annum. The bond amount will be amortised equally over its life. What is the
bond’s present value for an investor if he expects a minimum rate of return of 6 per cent?

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 COST OF CAPITAL

Answer :

The amount of interest will go on declining as the outstanding amount of bond will be
reducing due to amortisation. The amount of interest for five years will be:
First year : `5,000 x 0.08 = ` 400;
Second year : (`5,000 – `1,000) x 0.08 = ` 320;
Third year : (`4,000 – `1,000) x 0.08 = ` 240;
Fourth year : (`3,000 – `1,000) x 0.08 = ` 160; and
Fifth year : (`2,000 – `1,000) x 0.08 = ` 80.
The outstanding amount of bond will be zero at the end of fifth year.
Since RBML will have to return `1,000 every year, the outflows every year will consist of
interest payment and repayment of principal:
First year : `1,000 + ` 400 = `1,400;
Second year : `1,000 + ` 320 = `1,320;
Third year : `1,000 + ` 240 = `1,240;
Fourth year : `1,000 + ` 160 = `1,160; and
Fifth year : `1,000 + `80 = ` 1,080.
The above cash flows of all five years will be discounted with the cost of capital. Here the
expected rate i.e. 6% will be used.
Value of the bond is calculated as follows:
` 1, 400 ` 1, 320 ` 1, 240 ` 1, 160 ` 1, 080
VB =    
 1.06   1.06   1.06   1.06   1.06 
1 2 3 4 5

` 1, 400 ` 1, 320 ` 1, 240 ` 1, 160 ` 1, 080

=    
1.06 1.1236 1.1910 1.2624 1.3382
= `1,320.75 + `1,174.80 + `1,041.14 + `918.88 + `807.05 = ` 5,262.62

Question 5

XYZ Ltd. issues 2,000 10% preference shares of ` 100 each at ` 95 each. The company
proposes to redeem the preference shares at the end of 10th year from the date of issue.
Calculate the cost of preference share?

Answer :

PD 
 RV  NP 
Kp  n
 RV  NP 
2

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 100  95 
10   
Kp   10  =0.1077 (approx.) = 10.77%
 100  95 
 
 2 

Question 6

XYZ & Co. issues 2,000 10% preference shares of ` 100 each at ` 95 each. Calculate the cost
of preference shares.

Answer :

PD
Kp 
P0

Kp 
 10  2, 000   10  0.1053 = 10.53%
 95  2, 000  95

Question 7

If R Energy is issuing preferred stock at `100 per share, with a stated dividend of `12, and a
floatation cost of 3% then, what is the cost of preference share?

Answer :

Preferred stock dividend

Kp 
Market price of preferred stock (1 - floatation cost)
` 12 ` 12
=   0.1237 or 12.37
` 100  1  0.03  ` 97

Question 8

A company has paid dividend of ` 1 per share (of face value of ` 10 each) last year and it is
expected to grow @ 10% next year. Calculate the cost of equity if the market price of share is
` 55.

Answer :

D1 ` 1  1  0.1 
Ke  g   0.1  0.12  12%
P0 ` 55

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 COST OF CAPITAL

Dividend Discount Model with variable growth rate is explained in chapter 10 i.e. Dividend
Decision

Question 9

Mr. Mehra had purchased a share of Alpha Limited for ` 1,000. He received dividend for a
period of five years at the rate of 10 percent. At the end of the fifth year, he sold the share of
Alpha Limited for ` 1,128. You are required to compute the cost of equity as per realised
yield approach.

Answer :

We know that as per the realised yield approach, cost of equity is equal to the
realised rate of return. Therefore, it is important to compute the internal rate of
return by trial and error method. This realised rate of return is the discount rate
which equates the present value of the dividends received in the past five years plus
the present value of sale price of ` 1,128 to the purchase price of `1,000. The discount rate
which equalises these two is 12 percent approximately. Let us look at the table given for a
better understanding:
Year Dividend (`) Sale Proceeds (`) Discount Factor @ 12% Present Value (`)
1 100 - 0.893 89.3
2 100 - 0.797 79.7
3 100 - 0.712 71.2
4 100 - 0.636 63.6
5 100 - 0.567 56.7
6 Beginning 1,128 0.567 639.576
1,000.076

We find that the purchase price of Alpha limited’s share was ` 1,000 and the present value
of the past five years of dividends plus the present value of the sale price at the discount
rate of 12 per cent is `1,000.076. Therefore, the realised rate of return may be taken as 12
percent. This 12 percent is the cost of equity.

Question 10

Calculate the cost of equity capital of H Ltd., whose risk free rate of return equals 10%. The
firm’s beta equals 1.75 and the return on the market portfolio equals to 15%.

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Answer :

Ke = Rf + β (Rm − Rf)
Ke = 0.10 + 1.75 (0.15 − 0.10)
= 0.10 + 1.75 (0.05)
= 0.1875 or 18.75%

Question 11

ABC Company provides the following details:

D0 = ` 4.19 P0 = ` 50 g = 5%
Calculate the cost of retained earnings.

Answer :

D1 D 1  g 
Ks  g  0 g
P0 P0
` 4.19(1+0.05)
=  0.05
` 50
= 0.088 + 0.05 = 13.8%

Question 12

ABC Company provides the following details:

Rf = 7% β = 1.20 Rm - Rf = 6%
Calculate the cost of retained earnings based on CAPM method.

Answer :

Ks = Rf + β (Rm – Rf)
= 7% + 1.20 (6%) = 7% + 7.20
Ks = 14.2%

Question 13

Calculate the WACC using the following data by using:

a. Book value weights
b. Market value weights

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The capital structure of the company is as under:

`
Debentures (` 100 per debenture) 5,00,000
Preference shares (` 100 per share) 5,00,000
Equity shares (` 10 per share) 10,00,000
20,00,000

The market prices of these securities are:

Debentures ` 105 per debenture
Preference shares ` 110 per preference share
Equity shares ` 24 each.

Additional information:
1. ` 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10 year
maturity.
2. ` 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10
year maturity.
3. Equity shares has ` 4 floatation cost and market price ` 24 per share.

The next year expected dividend is ` 1 with annual growth of 5%. The firm has practice of
paying all earnings in the form of dividend.
Corporate tax rate is 50%.

Answer :

D1 `1
Cost of Equity Ke = g   0.05  0.1 or 10%
P0  F ` 24  ` 4

I 1  t 
 RV  NP   100  NP 
10  1  0.5    
n  n 
Cost of Debt (Ke) = =
 RV  NP   RV  NP 
 
2  2 
 100  96 
10  1  0.5    
 10   5  0.4 
Cost of debt = (Kd) =   = 0.055 (approx.)
 100  96   98 
 
 2 
 2 
 5  10   5.2 
Cost of preference shares =Kp =    0.053 (approx.)
198   99 
 
 2 

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a. Calculation of WACC using book value weights

Source of capital Book Value Weights After tax cost of WACC (Ko)
capital
a b (c) = (a)×(b)
10% Debentures 5,00,000 0.25 0.055 0.0137
5% Preference shares 5,00,000 0.25 0.053 0.0132
Equity shares 10,00,000 0.50 0.10 0.0500
20,00,000 1.00 0.0769

WACC (Ko) = 0.0769 or 7.69%

b. Calculation of WACC using market value weights

Source of capital Market Weights After tax cost of WACC (Ko)
Value capital
a b (c) = (a)×(b)
10% Debentures 5,25,000 0.151 0.055 0.008
5% Preference shares 5,50,000 0.158 0.053 0.008
Equity shares 24,00,000 0.691 0.10 0.069
34,75,000 1.000 0.085

WACC (Ko) = 0.085 or 8.5%

Question 14

ABC Ltd. has the following capital structure which is considered to be optimum as on 31st
March, 2017.
`
14% Debentures 30,000
11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000
The company share has a market price of ` 23.60. Next year dividend per share is 50% of
year 2017 EPS. The following is the trend of EPS for the preceding 10 years which is
expected to continue in future.
Year EPS (`) Year EPS (`)
2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36

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 COST OF CAPITAL

The company issued new debentures carrying 16% rate of interest and the current market
price of debenture is ` 96.

Preference share ` 9.20 (with annual dividend of ` 1.1 per share) were also issued. The
company is in 50% tax bracket.
A. Calculate after tax:
i. Cost of new debt
ii. Cost of new preference shares
iii. New equity share (consuming new equity from retained earnings)
B. Calculate marginal cost of capital when no new shares are issued.
C. How much can be spent for capital investment before new ordinary shares must be sold.
Assuming that retained earnings for next year’s investment are 50 percent of 2017.
D. What will the marginal cost of capital when the funds exceeds the amount calculated in
(C), assuming new equity is issued at ` 20 per share?

Answer :

A.
i. Cost of new debt
I 1  t
Kd 
P0
16 (1 - 0.5)
=  0.0833
96
ii. Cost of new preference shares
PD 1.1
Kp    0.12
P0 9.2

iii. Cost of new equity shares

D
Ke  1  g
P0
1.18
  0.10  0.05 + 0.10 = 0.15
23.60
Calculation of D1
D1 = 50% of 2013 EPS = 50% of 2.36 = ` 1.18

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B. Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product

1 2 3 (2) × (3) = 4
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.12 0.0060
Equity Share 0.80 0.15 0.1200
Marginal cost of capital 0.1385

C. The company can spend the following amount without increasing marginal cost of
capital and without selling the new shares:
Retained earnings = (0.50) (2.36 × 10,000) = ` 11,800
The ordinary equity (Retained earnings in this case) is 80% of total capital
11,800 = 80% of Total Capital
` 11,800
∴ Capital investment before issuing equity = = ` 14,750
0.80

D. If the company spends in excess of ` 14,750 it will have to issue new shares.
` 1.18
∴ Capital investment before issuing equity =  0.10  0.159
20
The marginal cost of capital will be:
Type of Capital Proportion Specific Cost Product
1 2 3 (2) × (3) = 4
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.1200 0.0060
Equity Share (new) 0.80 0.1590 0.1272
0.1457

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 PRACTICE QUESTIONS

Source : ICAI, SM (New) - (From Question 1- 4)

Question 1

Determine the cost of capital of Best Luck Limited using the book value (BV) and market
value (MV) weights from the following information:
Sources Book Value (`) Market Value(`)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000

Additional information :
i. Equity : Equity shares are quoted at ` 130 per share and a new issue priced at ` 125 per
share will be fully subscribed; flotation costs will be ` 5 per share.
ii. Dividend : During the previous 5 years, dividends have steadily increased from ` 10.60
to ` 14.19 per share. Dividend at the end of the current year is expected to be ` 15 per
share.
iii. Preference shares : 15% Preference shares with face value of ` 100 would realise ` 105
per share.
iv. Debentures : The company proposes to issue 11-year 15% debentures but the
yield on debentures of similar maturity and risk class is 16% ; flotation cost is 2%.
v. Tax : Corporate tax rate is 35%. Ignore dividend tax.

Answer :

D1 ` 15
i. Cost of Equity (Ke) = g =  0.06 (refer to working note)
P0  F ` 125  ` 5
Ke = 0.125 + 0.06 = 0.185

Working Note:
Calculation of 'g'
14.19
` 10.6(1+g)5 = ` 14.19 Or, (1+g)5 =  1.338
10.6
Table (FVIF) suggests that `1 compounds to `1.338 in 5 years at the compound
rate of 6 percent. Therefore, g is 6 per cent.

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D1 ` 15
iii. Cost of Retained Earnings (Ks) = g   0.06  0.18
P0 ` 125
PD ` 15
iv. Cost of Preference shares (Kp ) =   0.1429
P0 ` 105

I 1  t 
 RV  NP 
v. Cost of Debentures (Kd) = n
 RV  NP 
2
 ` 100  ` 91.75 * 
` 15  1  0.35    
 11 years 
=
` 100  ` 91.75 *
2
` 15  0.65  ` 0.75 ` 10.5
=   0.1095
` 95.875 ` 95.875
*Since yield on similar type of debentures is 16 per cent, the company would be
required to offer debentures at discount.
Market price of debentures (approximation method) = Coupon rate ÷ Market rate of
interest
= ` 15 ÷ 0.16 = ` 93.75
Sale proceeds from debentures = `93.75 – ` 2 (i.e., floatation cost) = `91.75

Market value (P0) of debentures can also be found out using the present value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%, 11
years)
P0 = `15 × 5.029 + `100 × 0.195
P0 = `75.435 + `19.5 = ` 94.935
Net Proceeds = `94.935 – 2% of `100 = ` 92.935
Accordingly, the cost of debt can be calculated

Cost of Capital (amount in lakh of rupees)

[BV weights and MV weights]
Specific
Weights Total cost
Source of capita Cost (K)
BV MV (BV × K) (MV × K)
Equity Shares 120 160* 0.1850 22.2 29.6
Retained Earnings 30 40* 0.1800 5.4 7.2
Preference Shares 9 10.4 0.1429 1.29 1.49
Debentures 36 33.75 0.1095 3.94 3.70
Total 195 244.15 32.83 41.99

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*Market Value of equity has been apportioned in the ratio of Book Value of equity
and retained earnings

Weighted Average Cost of Capital (WACC):

` 32.83
Using Book Value =  0.1684 or 16.84%
` 195
` 41.99
Using Market Value = = 0.172 or 17.2%
` 244.15

Question 2

Gamma Limited has in issue 5,00,000 `1 ordinary shares whose current ex-dividend
market price is ` 1.50 per share. The company has just paid a dividend of 27 paise per
share, and dividends are expected to continue at this level for some time. If the company
has no debt capital, what is the weighted average cost of capital?

Answer :

Market value of equity, E = 5,00,000 shares  `1.50 = `7,50,000

Market value of debt, D = Nil
D ` 0.27
Cost of equity capital, Ke = 1   0.18
P0 ` 1.50
Since there is no debt capital, WACC = Ke = 18 per cent.

Question 3

Masco Limited wishes to raise additional finance of ` 10 lakhs for meeting its investment
plans. It has ` 2,10,000 in the form of retained earnings available for investment purposes.
Further details are as following:
1. Debt / equity mix 30%/70%
2. Cost of debt
Upto ` 1,80,000 10% (before tax)
Beyond ` 1,80,000 16% (before tax)
3. Earnings per share `4
4. Dividend pay out 50% of earnings
5. Expected growth rate in dividend 10%
6. Current market price per share ` 44
7. Tax rate 50%

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You are required:

a. To determine the pattern for raising the additional finance.
b. To determine the post-tax average cost of additional debt.
c. To determine the cost of retained earnings and cost of equity, and
d. Compute the overall weighted average after tax cost of additional finance.

Answer :

a. Pattern of rising additional finance

Equity 70% of ` 10,00,000 = ` 7,00,000
Debt 30% of ` 10,00,000 = ` 3,00,000
The capital structure after rising additional finance
(`)
Shareholders’ funds
Equity Capital (7,00,000–2,10,000 ) 4,90,000
Retained earnings 2,10,000
Debt (Interest at 10% p.a.) 1,80,000
(Interest at 16% p.a.) (3,00,000–1,80,000) 1,20,000
Total Funds 10,00,000

b. Determination of post-tax average cost of additional debt

Kd = I(1-t)
Where,
I = Interest Rate
t = Corporate tax-rate
On ` 1,80,000 = 10% (1 – 0.5) = 5% or 0.05
On ` 1,20,000 = 16% (1 – 0.5) = 8% or 0.08

Average Cost of Debt =

 ` 1, 80, 000  0.05    ` 1, 20, 000  0.08   100  6.2%
` 3, 00, 000
c. Determination of cost of retained earnings and cost of equity applying dividend growth
model :
D
Ke  1  g
P0
Where,
Ke = Cost of equity
D1 = DO(1+ g)
D0 = Dividend paid (i.e., 50% of EPS = 50% × ` 4 = ` 2)
g = Growth rate

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P0 = Current market price per share

` 2  1.1  ` 2.2
Ke   0.10   0.10  0.05+0.10 = 0.15 = 15%
` 44 ` 44

d. Computation of overall weighted average after tax cost of additional finance

(`) Weights Cost of Weighted
Particular
funds Cost (%)
Equity (including retained earnings) 7,00,000 0.70 15% 10.5
Debt 3,00,000 0.30 6.2% 1.86
WACC 10,00,000 12.36

Question 4

The following details are provided by the GPS Limited :

(`)
Equity Share Capital 65,00,000
12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000

The cost of equity capital for the company is 16.30% and Income Tax rate for the company
is 30%.
You are required to calculate the Weighted Average Cost of Capital (WACC) of the
company.

Answer :

Calculation of Weighted Average Cost of Capital (WACC)

Amount Weight Cost of WACC
Source (`) Capital
after tax
Equity Capital 65,00,000 0.619 0.163 0.1009
12% Preference Capital 12,00,000 0.114 0.120 0.0137
15% Redeemable Debentures 20,00,000 0.190 0.105* 0.020
10% Convertible Debentures 8,00,000 0.076 0.07** 0.0053
Total 1,05,00,000 1.0000 0.1399

* Cost of Debentures (after tax) = 15 (1 – 0.30) = 10.5% = 0.105

** Cost of Debentures (after tax) = 10 (1 – 0.30) = 7% = 0.07
Weighted Average Cost of Capital = 0.1399 = 13.99%
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(Note: In the above solution, the Cost of Debentures has been computed in the above
manner without considering the impact of special features i.e. redeemability and
convertibility in absence of requisite information.)

Source : ICAI, PM (Old) - (From Question 5 -21 )

Question 5

A Company issues `10,00,000 , 12% debentures of `100 each. The debentures are
redeemable after the expiry of fixed period of 7 years. The Company is in 35% tax bracket.

Required:
i. Calculate the cost of debt after tax, if debentures are issued at
a. Par ;
b. 10% Discount;
c. 10% Premium.
ii. If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?

Answer :

i. Calculation of Cost of Debt after tax:

I 1  t 
 RV  NP 
Cost of Debt (Kd) = n
 RV  NP 
2
Where,
I = Annual Interest Payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
t = Income tax rate
n = Life of debentures

a. Cost of 12% Debentures, if issued at par:

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b. Cost of 12% Debentures, if issued at 10% discount:

or, 9.71%

c. Cost of 12% Debentures, if issued at 10% Premium:

= 0.0607 or 6.07%

ii. Cost of 12% Debentures, if brokerage is paid at 2% and debentures are issued at par:

* Net Proceeds = Par value of shares – 2% Brokerage of par value

= `10,00,000 – 2% of `10,00,000 = `9,80,000

Question 6

Y Ltd. retains ` 7,50,000 out of its current earnings. The expected rate of return to the
shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and the
shareholders come in 30% tax bracket. Calculate the cost of retained earnings.

Answer :

Computation of Cost of Retained Earnings (Kr)

Ks = k (1 - tP) - Brokerage
Where, k = Opportunity cost; tp = Shareholders’ personal tax
Ks = 0.10 (1- 0.30) - 0.03 = 0.04 or 4%

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Alternatively
Cost of Retained earnings is equal to opportunity cost for benefits forgone by the
shareholders
(`)
Earnings before tax (10% of `7,50,000) 75,000
Less: Tax (30% of `75,000) (22,500)
After tax earnings 52,500
Less: Brokerage (3% of `7,50,000) (22,500)
Net earnings 30,000
Total Investment 7,50,000
` 30,000
Effective Rate of earnings=  100 4%
`7, 50, 000

Question 7

PQR Ltd. has the following capital structure on October 31, 2015:
Sources of capital (`)
Equity Share Capital (2,00,000 Shares of ` 10 each) 20,00,000
Reserves & Surplus 20,00,000
12% Preference Shares 10,00,000
9% Debentures 30,00,000
80,00,000

The market price of equity share is ` 30. It is expected that the company will pay next year a
dividend of ` 3 per share, which will grow at 7% forever. Assume 40% income tax rate.
You are required to compute weighted average cost of capital using market value
weights.

Answer :

D1 `3
i. Cost of Equity (Ke) = g   0.07 = 0.1 + 0.07 = 0.17 =17%
P0 ` 30
ii. Cost of Debentures (Kd) = I (1 - t) = 0.09 (1 - 0.4) = 0.054 or 5.4%
Computation of Weighted Average Cost of Capital (WACC using market value
weights)

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Market Value Weight Cost of WACC(%)

Source of capital
of capital (`) Capital
9% Debentures 30,00,000 0.30 5.40 1.62
12% Preference Shares 10,00,000 0.10 12.00 1.20
Equity Share Capital 60,00,000 0.60 17.00 10.20
(`30 × 2,00,000 shares)
Total 1,00,00,000 1.00 13.02

Question 8

A company issued 40,000, 12% Redeemable Preference Share of ` 100 each at a premium of
` 5 each, redeemable after 10 years at a premium of ` 10 each. The floatation cost of each
share is ` 2.
You are required to calculate cost of preference share capital ignoring dividend tax.

Answer :

Calculation of Cost of Preference Shares (Kp)

Preference Dividend (PD) = `100 × 40,000 shares × 0.12 = `4,80,000
Floatation Cost = 40,000 shares × `2 = ` 80,000
Net Proceeds (NP) = `105 × 40,000 shares – ` 80,000 = ` 41,20,000
Redemption Value (RV) = 40,000 × ` 110 = ` 44,00,000
PD   RV  NP  /N
Cost of Redeemable Preference Shares =
RV  NP
2

KP =

= 0.1192 or 11.92%

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Question 9

The following is the capital structure of Simons Company Ltd. as on 31.12.2015:

(`)
Equity shares : 10,000 shares (of ` 100 each) 10,00,000
10% Preference Shares (of ` 100 each) 4,00,000
12% Debentures 6,00,000
20,00,000

The market price of the company’s share is ` 110 and it is expected that a dividend of ` 10
per share would be declared for the year 20X6. The dividend growth rate is 6%:

i. If the company is in the 50% tax bracket, compute the weighted average cost of capital.
ii. Assuming that in order to finance an expansion plan, the company intends to borrow a
fund of ` 10 lakhs bearing 14% rate of interest, what will be the company’s revised
weighted average cost of capital? This financing decision is expected to increase
dividend from ` 10 to ` 12 per share. However, the market price of equity share is
expected to decline from ` 110 to ` 105 per share.

Answer :

i. Computation of the weighted average cost of capital (using market value weights*)
Market Weight After tax WACC (%)
Source of finance
Value of Cost of
capital (`) capital (%)
(a) (b) (c) (d) = (b) × (c)

Equity share (Working note 1) 11,00,000 0.5238 15.09 7.9041

[`110 × 10,000 shares]
10% Preference share 4,00,000 0.1905 10.00 1.9050
12% Debentures 6,00,000 0.2857 6.00 1.7142
21,00,000 1.0000 11.5233

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ii. Computation of Revised Weighted Average Cost of Capital (using market value
weights*)
Market Weight After tax WACC (%)
Source of finance
Value of Cost of
capital (`) capital (%)
(a) (b) (c) (d) = (b) × (c)

Equity share (Working note 2) 10,50,000 0.3443 17.43 6.0011

[`105 × 10,000 shares]
10% Preference share 4,00,000 0.1311 10.00 1.3110
12% Debentures 6,00,000 0.1967 6.00 1.1802
14% Loan 10,00,000 0.3279 7.00 2.2953
30,50,000 1.0000 10.7876
(*This can also be calculated using book value weights.)

Working Notes:

1. Cost of equity shares (Ke)

Dividend per share (D 1 )
Ke = +Growth rate (g)
Market price per share (P0 )

2. Revised cost of equity shares (Ke)

` 12
Revised Ke =  0.06  0.1742 or 17.43%
` 105

Question 10

XYZ Ltd. has the following book value capital structure:

Equity Capital (in shares of ` 10 each, fully paid up- at par) ` 15 crores
11% Preference Capital (in shares of ` 100 each, fully paid up- at par) ` 1 crore
Retained Earnings ` 20 crores
13.5% Debentures (of ` 100 each) ` 10 crores
15% Term Loans ` 12.5 crores
The next expected dividend on equity shares per share is ` 3.60; the dividend per share is
expected to grow at the rate of 7%. The market price per share is ` 40.
Preference stock, redeemable after ten years, is currently selling at ` 75 per share.
Debentures, redeemable after six years, are selling at ` 80 per debenture.
The Income tax rate for the company is 40%.

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i. Required
Calculate the current weighted average cost of capital using:
a. book value proportions; and
b. market value proportions.

ii. Define the weighted marginal cost of capital schedule for the company, if it raises ` 10
crores next year, given the following information:
a. the amount will be raised by equity and debt in equal proportions;
b. the company expects to retain ` 1.5 crores earnings next year;
c. the additional issue of equity shares will result in the net price per share being fixed
at ` 32;
d. the debt capital raised by way of term loans will cost 15% for the first ` 2.5 crores
and 16% for the next ` 2.5 crores.

Answer :

i.
a. Statement showing computation of weighted average cost of capital by using Book
value proportions
Amount Weight Cost of Weighted
Source of finance (Book (Book capital (%) cost of
value) value capital (%)
proportion)
(` in crores)
(a) (b) (c) = (a)(b)
Equity capital (W.N.1) 15.00 0.256 16.00 4.096
11% Preference capital (W.N.2) 1.00 0.017 15.43 0.262
Retained earnings (W.N.1) 20.00 0.342 16.00 5.472
13.5% Debentures (W.N.3) 10.00 0.171 12.70 2.171
15% term loans (W.N.4) 12.50 0.214 9.00 1.926
58.50 1.000 13.927

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b. Statement showing computation of weighted average cost of capital by using market

value proportions
Amount Weight Cost of Weighted
Source of finance (` in crores) (Market capital cost of
value (%) capital (%)
proportions)

(a) (b) (c) = (a)(b)

Equity capital (W.N.1) 60.00 0.739 16.00 11.824
(1.5 crores  `
40)
11% Preference capital (W.N.2) 0.75 0.009 15.43 0.138
(1 lakh  ` 75)
13.5% Debentures (W.N.3) 8.00 0.098 12.70 1.245
(10 lakhs  ` 80)
15% term loans (W.N.4) 12.50 0.154 9.00 1.386
81.25 1.00 14.593

[Note: Since retained earnings are treated as equity capital for purposes of calculation of
cost of specific source of finance, the market value of the ordinary shares may be
taken to represent the combined market value of equity shares and retained earnings. The
separate market values of retained earnings and ordinary shares may also be worked out
by allocating to each of these a percentage of total market value equal to their percentage
share of the total based on book value.]

Working Notes (W.N.):

1. Cost of equity capital and retained earnings (Ke)

D1
Ke = g
P0
Where,
Ke = Cost of equity capital
D1 = Expected dividend at the end of year 1
P0 = Current market price of equity share
g = Growth rate of dividend
Now, it is given that D1 = ` 3.60, P0 = ` 40 and g = 7%
Therefore

Or, Ke = 16%

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2. Cost of preference capital (Kp)

PD 
 RV  NP 
Kp  n
 RV  NP 
2
Where,
PD = Preference dividend
RV = Redeemable value of preference shares
NP = Current market price of preference shares
n =Redemption period of preference shares
Now, it is given that PD = 11%, RV = ` 100, NP = ` 75 and n = 10 years

Therefore

3. Cost of debentures (Kd)

I 1  t 
 RV  NP 
Kd = n
 RV  NP 
2
Where,
I = Interest payment
t = Tax rate applicable to the company
RV = Redeemable value of debentures
NP = Current market price of debentures
n = Redemption period of debentures
Now it is given that I = 13.5, t = 40%, RV = ` 100, NP = ` 80 and n = 6 years

Therefore,

4. Cost of Term loans (Kt)

Kt = = r(1-t)
Where,
r = Rate of interest on term loans
t = Tax rate applicable to the company

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Now,
r = 15% and t = 40%
Therefore, Kt = 15% (1 - 0.40) = 9%

ii. Statement showing weighted marginal cost of capital schedule for the company, if it
raises ` 10 crores next year, given the following information:
After tax Weighted
Source of finance cost of Average cost
Amount Weight
capital (%) of capital
(` in crores) (a)
(b) (%)
(c) = (a)(b)
Equity shares (W.N.5) 3.5 0.35 18.25 6.387
Retained earnings 1.5 0.15 18.25 2.737
15% Debt (W.N.6) 2.5 0.25 9.00 2.250
16% of Debt (W.N.6) 2.5 0.25 9.60 2.400
10.0 1.00 13.774

Working Notes (W.N.):

5. Cost of equity share (Ke) (including fresh issue of equity shares)

D1
Ke = g
P0
Now, D1 = ` 3.60, P0 = ` 32 and g = 0.07

Therefore ,

6. Cost of debt (Kd) = r (1- t)

(For first ` 2.5 crores)
r = 15% and t = 40%
Therefore, Kd = 15% (1- 40%) = 9%
(For the next 2.5 crores )
r = 16% and t = 40%
Therefore, Kd = 16% (1 - 40%) = 9.6%

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Question 11

JKL Ltd. has the following book-value capital structure as on March 31, 2015.
(`)
Equity share capital (2,00,000 shares) 40,00,000
11.5% Preference shares 10,00,000
10% Debentures 30,00,000
80,00,000

The equity shares of the company are sold for ` 20. It is expected that the company will pay
next year a dividend of ` 2 per equity share, which is expected to grow by 5% p.a. forever.
Assume a 35% corporate tax rate.

Required:
i. Compute weighted average cost of capital (WACC) of the company based on the
existing capital structure.
ii. Compute the new WACC, if the company raises an additional ` 20 lakhs debt by issuing
12% debentures. This would result in increasing the expected equity dividend to ` 2.40
and leave the growth rate unchanged, but the price of equity share will fall to `
16 per share.

Answer :

i. Computation of Weighted Average Cost of Capital based on existing capital structure

Source of Capital Weights After tax WACC (%)
Existing Capital cost of
structure (`) capital (%)
(a) (b) (a)(b)
Equity share capital (W.N.1) 40,00,000 0.500 15.00 7.500
11.5% Preference share capital
10,00,000 0.125 11.50 1.437
(W.N.2)
10% Debentures (W.N.3) 30,00,000 0.375 6.50 2.438
80,00,000 1.000 11.375

Working Notes (W.N.):

1. Cost of equity capital:

Expected Dividend (D 1 )
Ke = +Growth (g)
Current Market price per share (P0 )

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2. Cost of preference share capital:

Annual preference share dividend (PD)
Net proceeds in the issue of preference share (NP)
` 1,15,000
= =0.115 or 11.5%
` 10,00,000

3. Cost of 10% Debentures:

ii. Computation of Weighted Average Cost of Capital based on new capital structure
Source of Capital Weights After tax WACC (%)
New Capital cost of
structure (`) capital (%)
(b) (a) (a)(b)
Equity share capital (W.N. 4) 40,00,000 0.40 20.00 8.00
Preference share (W.N. 2) 10,00,000 0.10 11.50 1.15
10% Debentures (W.N. 3) 30,00,000 0.30 6.50 1.95
12% Debentures (W.N.5) 20,00,000 0.20 7.80 1.56
1,00,00,000 1.00 12.66

Working Notes (W.N.):

4. Cost of equity capital:

Expected Dividend (D 1 ) ` 2.40
Ke = +Growth (g) =  5%  20%
Current Market price per share (P0 ) ` 16

5. Cost of 12% Debentures

Question 12

ABC Limited has the following book value capital structure:

Equity Share Capital (150 million shares, `10 par) ` 1,500 million
Reserves and Surplus ` 2,250 million
10.5% Preference Share Capital (1 million shares, `100 par) ` 100 million
9.5% Debentures (1.5 million debentures, `1,000 par) ` 1,500 million
8.5% Term Loans from Financial Institutions ` 500 million

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The debentures of ABC Limited are redeemable after three years and are quoting at ` 981.05
per debenture. The applicable income tax rate for the company is 35%.

The current market price per equity share is ` 60. The prevailing default-risk free interest
rate on 10- year GOI Treasury Bonds is 5.5%. The average market risk premium is 8%. The
beta of the company is 1.1875.

The preferred stock of the company is redeemable after 5 years is currently selling at ` 98.15
per preference share.

Required:
i. Calculate weighted average cost of capital of the company using market value weights.
ii. Define the marginal cost of capital schedule for the firm if it raises ` 750 million for a
new project. The firm plans to have a debt of 20% of the newly raised capital. The beta
of new project is 1.4375. The debt capital will be raised through term loans, it will carry
interest rate of 9.5% for the first `100 million and 10% for the next ` 50 million.

Answer :

Working Notes:

1. Computation of cost of debentures (Kd) :

2. Computation of cost of term loans (KT) :

= r ( 1- t)
= 0.085( 1 - 0.35) = 0.05525 or 5.525%

3. Computation of cost of preference capital (KP) :

Preference Dividend + (RV - NP) / n
Kp =
(RV + NP) / 2
10.5 + (100 - 98.15) / 5
= =0.1097 = 10.97%
(100 + 98.15) / 2

4. Computation of cost of equity (Ke) :

= Rf + β(Rm – Rf)
Or, = Risk free rate + (Beta × Risk premium)
= 0.055 + (1.1875  0.08) = 0.15 or 15%

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i. Calculation of Weighted Average cost of capital Using market value weights

Market value of After tax
cost of
Source of Capital capital structure Weights WACC (%)
capital (%)
(` in millions)
Equity share capital 9,000 0.813 15.000 12.195
(150 million share  ` 60)
10.5% Preference share capital
98.15 0.0089 10.970 0.098
(1 million shares  `98.15)
9.5 % Debentures 1,471.575 0.1329 6.872 0.913
(1.5 million  `981.05)
8.5% Term loans 500 0.0452 5.525 0.249
11,069.725 1.000 13.455

ii. Marginal cost of capital (MCC) schedule :

New capital of `750 million will be raised in proportion of 20% Debt and 80% equity
share capital i.e. `150 million debt and `600 million equity.
Cost of equity shares (Ke) = Risk free rate + (Beta × Risk premium)
= 0.055 + (1.4375 × 0.08) = 0.17 or 17%
Cost of Debt (Kd):
for first `100 million = 9.5%  (1 - 0.35) = 6.175%
for next `50 million = 10%  (1 - 0.35) = 6.5%

Marginal Cost of Capital =

= 0.136 + (0.008 + 0.004) = 0.148 or 14.8%

Question 13

The R&G Ltd. has following capital structure at 31st December 2015, which is
considered to be optimum:
(`)
13% Debenture 3,60,000
11% Preference share capital 1,20,000
Equity share capital (2,00,000 shares) 19,20,000

The company’s share has a current market price of `27.75 per share. The expected dividend
per share in next year is 50 percent of the 2015 EPS. The EPS of last 10 years is as follows.
The past trends are expected to continue:

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Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
EPS(`) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773

The company can issue 14 percent new debenture. The company’s debenture is currently
selling at ` 98. The new preference issue can be sold at a net price of ` 9.80, paying a
dividend of ` 1.20 per share. The company’s marginal tax rate is 50%.

i. Calculate the after tax cost (a) of new debts and new preference share capital, (b) of
ordinary equity, assuming new equity comes from retained earnings.
ii. Calculate the marginal cost of capital.
iii. How much can be spent for capital investment before new ordinary share must
be sold? (Assuming that retained earnings available for next year’s investment is 50%
of 2015 earnings.)
iv. What will be marginal cost of capital (cost of fund raised in excess of the amount
calculated in part (iii) if the company can sell new ordinary shares to net ` 20 per share ?
The cost of debt and of preference capital is constant.

Answer :

i. Calculation of after tax cost of the followings:

a. New 14% Debentures (Kd) =

PD ` 1.20
New 12% Preference Shares (Kp) =   0.1224 or 12.24%
NP ` 9.80

b. Equity Shares (Retained Earnings) (Ke)

Expected dividend(D 1 )
=  Growth rate (G)
Current market price (P0 )
50% of ` 2.773
=  0.12*  0.17 or 17%
` 27.75
* Growth rate (on the basis of EPS) is calculated as below :
EPS in current year - EPS in previous year
=
EPS in previous year

(Students may verify the growth trend by applying the above formula to last three or
four years)

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ii. Calculation of marginal cost of capital (on the basis of existing capital structure):
After tax cost of
Weights WACC (%)
Source of Capital capital (%)
(a) (a)(b)
(b)
14% Debenture 0.15 7.14 1.071
12% Preference shares 0.05 12.24 0.612
Equity shares 0.80 17.00 13.600
Marginal cost of capital 15.283

iii. The company can spent for capital investment before issuing new equity shares
and without increasing its marginal cost of capital:
Retained earnings can be available for capital investment
= 50% of 2015 EPS × equity shares outstanding
= 50% of ` 2.773 × 2,00,000 shares = `2,77,300
Since, marginal cost of capital is to be maintained at the current level i.e. 15.28%, the
retained earnings should be equal to 80% of total additional capital for investment.
` 2,77,300
Thus investment before issuing equity=  100  ` 3,46,625
80
The remaining capital of ` 69,325 i.e. ` 3,46,625 – ` 2,77,300 shall be financed by issuing
14% Debenture and 12% preference shares in the ratio of 3 : 1 respectively.

iv. If the company spends more than ` 3,46,625 as calculated in part (iii) above, it will have
to issue new shares at ` 20 per share.
The cost of new issue of equity shares will be:

Calculation of marginal cost of capital (assuming the existing capital structure will be
maintained):
Weights Cost (%) WACC (%)
Source of Capital
(a) (b) (a)(b)
14% Debenture 0.15 7.14 1.071
12% Preference shares 0.05 12.24 0.612
Equity shares 0.80 18.93 15.144
Marginal cost of capital 16.827

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Question 14

You are required to determine the weighted average cost of capital of a firm using (i) book-
value weights and (ii) market value weights. The following information is available for
your perusal:
Present book value of the firm’s capital structure is:
(`)
Debentures of ` 100 each 8,00,000
Preference shares of ` 100 each 2,00,000
Equity shares of ` 10 each 10,00,000
20,00,000

All these securities are traded in the capital markets. Recent prices are:
Debentures @ ` 110, Preference shares @ ` 120 and Equity shares @ ` 22.
Anticipated external financing opportunities are as follows:
i. ` 100 per debenture redeemable at par : 20 years maturity 8% coupon rate, 4% floatation
costs, sale price ` 100.
ii. ` 100 preference share redeemable at par : 15 years maturity, 10% dividend rate, 5%
floatation costs, sale price ` 100.
iii. Equity shares : ` 2 per share floatation costs, sale price ` 22.
In addition, the dividend expected on the equity share at the end of the year is ` 2 per
share; the anticipated growth rate in dividends is 5% and the firm has the practice of
paying all its earnings in the form of dividend. The corporate tax rate is 50%.

Answer :

Working Notes:

Determination of Cost of capital:

i. Cost of Debentures (Kd )

I 1  t 
 RV  NP 
Kd = n
 RV  NP 
2
Where,
I = Annual Interest Payment
NP = Net proceeds of debentures net of flotation costs
RV = Redemption value of debentures
t = Income tax rate
n = Life of debentures

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* Net Proceeds = Par value per shares - 4% Flotation cost per share
= `100 – 4% of `100 = `96

ii. Cost of Preference Shares (Kp)

PD 
 RV  NP 
Kp  n
 RV  NP 
2
Where,
PD = Preference Dividend per share
NP = Net proceeds of share net of flotation costs
RV = Redemption value of shares
n = Life of preference shares

* Net Proceeds = Par value per shares - 5% Flotation cost per share
= ` 100 – 5% of `100 = `95

iii. Cost of Equity (Ke)

Expected dividend(D 1 ) `2
Ke =  Growth rate (G) =  0.05= 0.15 or 15%
Current market price (P0 ) ` 22  ` 2

i. Computation of Weighted Average Cost of Capital based on Book Value Weights

Weights After tax
Book Value
Source of Capital to Total Cost of WACC (%)
(`)
Capital capital (%)
Debentures 8,00,000 0.40 4.29 1.716
Preference Shares 2,00,000 0.10 10.60 1.060
Equity Shares 10,00,000 0.50 15.00 7.500
20,00,000 1.00 10.276

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ii. Computation of Weighted Average Cost of Capital based on Market Value Weights
Market Weights After tax
Source of Capital Value to Total Cost of WACC (%)
(`) Capital capital (%)
Debentures (8,000 units × `110) 8,80,000 0.2651 4.29 1.137
Pref. Shares (2,000 shares × `120) 2,40,000 0.0723 10.60 0.766
Equity Shares (1,00,000 shares × `22) 22,00,000 0.6626 15.00 9.939
33,20,000 1.000 11.842

Question 15

The following is the capital structure of a Company:

Source of capital Book value Market value
(`) (`)
Equity shares @ ` 100 each 80,00,000 1,60,00,000
9% Cumulative preference shares @ ` 100 each 20,00,000 24,00,000
11% Debentures 60,00,000 66,00,000
Retained earnings 40,00,000 -
2,00,00,000 2,50,00,000

The current market price of the company’s equity share is ` 200. For the last year the
company had paid equity dividend at 25 per cent and its dividend is likely to grow 5 per
cent every year. The corporate tax rate is 30 per cent and shareholders personal income tax
rate is 20 per cent.

You are required to calculate:

i. Cost of capital for each source of capital.
ii. Weighted average cost of capital on the basis of book value weights.
iii. Weighted average cost of capital on the basis of market value weights.

Answer :

i. Calculation of Cost of Capital for each source of capital:

a. Cost of Equity share capital:

` 26.25
=  0.05= 0.18125 or 18.125%
` 200

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b. Cost of Preference share capital (Kp) = 9%

c. Cost of Debentures (Kd) = r (1 – t)

= 11% (1-0.3) =7.7%

d. Cost of Retained Earnings: Ks =Ke (1 – tp) = 18.125 (1 – 0.2) = 14.5%

ii. Weighted Average Cost of Capital on the basis of book value weights
After tax
WACC (%)
Amount Weights Cost of
Source
(`) (a) capital (%)
(c) = (a)  (b)
(b)
Equity share 80,00,000 0.40 18.125 7.25
9% Preference share 20,00,000 0.10 9.000 0.90
11% Debentures 60,00,000 0.30 7.700 2.31
Retained earnings 40,00,000 0.20 14.500 2.90
2,00,00,000 1.00 13.36

iii. Weighted Average Cost of Capital on the basis of market value weights
After tax
WACC (%)
Amount Weights Cost of
Source
(`) (a) capital (%)
(c) = (a)  (b)
(b)
Equity share 1,60,00,000 0.640 18.125 11.60
9% Preference share 24,00,000 0.096 9.000 0.864
11% Debentures 66,00,000 0.264 7.700 2.033
2,50,00,000 1.000 14.497

Question 16

The capital structure of a company as on 31st March, 2015 is as follows:

(`)
Equity share capital : 6,00,000 equity shares of ` 100 each 6,00,00,000
Reserve and surplus 1,20,00,000
12% Debenture of ` 100 each 1,80,00,000
For the year ended 31st March, 20X5 the company has paid equity dividend @24%.
Dividend is likely to grow by 5% every year. The market price of equity share is ` 600 per
share. Corporate tax rate applicable to the company is 30%.

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Required:
i. Compute the current weighted average cost of capital.
ii. The company has plan to raise a further ` 3,00,00,000 by way of long-term loan at 18%
interest. If loan is raised, the market price of equity share is expected to fall to ` 500 per
share. What will be the new weighted average cost of capital of the company?

Answer :

i. Computation of Current Weighted Average Cost of Capital

a. Cost of 12% Debentures (Kd)

b. Cost of Equity Share Capital (Ke)

` 25.2
=  0.05= 0.092 or 9.2%
` 600
After tax
Amount
Source of capital Weight Cost of WACC (%)
(`)
capital (%)
Equity share capital (including
7,20,00,000 0.80 9.20 7.36
Reserve & Surplus)
12% Debentures 1,80,00,000 0.20 8.40 1.68
Weighted Average Cost of Capital 9.04

ii. Computation of New Weighted Average Cost of Capital

a. Cost of Existing 12% Debentures (Kd) = 8.4 % (as calculated above)

b. Cost of Term Loan (Kt) = Rate of Interest (r) × (1-tax rate)

= 0.18 (1-.03) = 0.126 or 12.6%

c. Cost of Equity Share Capital (Ke)

= 0.0504 + 0.05 = 0.1004 = 10.04%

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After tax
Amount
Source of capital Weight Cost of WACC (%)
(`)
capital (%)
Equity share capital (including
7,20,00,000 0.60 10.04 6.02
Reserve & Surplus)
12% Debentures 1,80,00,000 0.15 8.40 1.26
18% Term loan 3,00,00,000 0.25 12.60 3.15
Weighted Average Cost of Capital 10.43
[WACC for the company can also be calculated using market value weights]

Question 17

The capital structure of a company consists of equity shares of ` 50 lakhs; 10 percent

preference shares of ` 10 lakhs and 12 percent debentures of ` 30 lakhs. The cost of equity
capital for the company is 14.7 percent and income-tax rate for this company is 30 percent.
You are required to calculate the Weighted Average Cost of Capital (WACC).

Answer :

Calculation of Weighted Average Cost of Capital (WACC)

Cost of
Amount
Source Weight capital WACC
(`)
after tax
Equity Capital 50,00,000 0.5556 0.147 0.0817
10% Preference Capital 10,00,000 0.1111 0.100 0.0111
12% Debentures 30,00,000 0.3333 0.084* 0.0280
Total 90,00,000 1.0000 0.1208

* Cost of Debentures (after tax) = 12% (1 – 0.30) = 8.4% = 0.084

Weighted Average Cost of Capital = 0.1208 = 12.08%

Question 18

ABC Ltd. wishes to raise additional finance of ` 20 lakhs for meeting its investments plan.
The company has ` 4,00,000 in the form of retained earnings available for investment
purposes. The following are the further details:
- Debt equity ratio 25 : 75.
- Cost of debt at the rate of 10% (before tax) upto ` 2,00,000 and 13% (before tax)
beyond that.
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- Earnings per share ` 12.

- Dividend payout 50% of earnings.
- Expected growth rate in dividend 10%.
- Current market price per share, ` 60.
- Company’s tax rate is 30% and shareholder’s personal tax rate is 20%.

Required:
i. Calculate the post tax average cost of additional debt.
ii. Calculate the cost of retained earnings and cost of equity.
iii. Calculate the overall weighted average (after tax) cost of additional finance.

Answer :

Pattern of raising Capital:

Portion of Debt = ` 20,00,000 × 25% = ` 5,00,000 and
Portion of Equity = ` 20,00,000 × 75% = ` 15,00,000, of this ` 4,00,000 is from retained
earnings and `11,00,000 by issuing fresh equity shares.

Total Interest(1 - t)
i. Cost of Debt (Kd) =
Debt

EPS  Payout ratio (1 + g)

ii. Cost of Equity (Ke) = g
P0

Cost of retained earnings (Ks) = Ke (1 – tp) = 0.21(1 - 0.2) = 0.168 or 16.8%

iii. Weighted average cost of capital (Ko)

Proportion Cost of
Amount
Source of capital of total Capital WACC(%)
(`)
Capital (%)
Equity Capital 11,00,000 0.55 21.00 11.550
Retained earning 4,00,000 0.20 16.80 3.360
Debt 5,00,000 0.25 8.26 2.065
Total 20,00,000 1.00 16.975

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Question 19

The capital structure of MNP Ltd. is as under:

9% Debenture ` 2,75,000
11% Preference shares ` 2,25,000
Equity shares (face value : ` 10 per share) ` 5,00,000
` 10,00,000

Additional information:
i. ` 100 per debenture redeemable at par has 2% floatation cost and 10 years of maturity.
The market price per debenture is ` 105.
ii. ` 100 per preference share redeemable at par has 3% floatation cost and 10 years
of maturity. The market price per preference share is ` 106.
iii. Equity share has ` 4 floatation cost and market price per share of ` 24. The next
year expected dividend is ` 2 per share with annual growth of 5%. The firm has a
practice of paying all earnings in the form of dividends.
iv. Corporate Income-tax rate is 35%.

Required :
Calculate Weighted Average Cost of Capital (WACC) using market value weights.

Answer :

i. Cost of Equity (Ke)

ii. Cost of Debt (kd)

* NP = `100 – 2% of `100 = `98

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iii. Cost of Preference Shares (kp)

* NP = `100 – 3% of `100 = `97

Calculation of WACC using Market Value Weights

Market Weights After tax
Source of capital Value to Total cost of WACC(%)
(`) Capital capital (%)
9% Debentures
2,88,750 0.1672 6.11 1.02
(`105 × 2,750 debentures)
11% Preference Shares
2,38,500 0.1381 11.47 1.58
(`106 × 2,250 preference share)
Equity Shares
12,00,000 0.6947 15.00 10.42
(` 24 × 50,000 shares)
17,27,250 1.000 13.02

Question 20

SK Limited has obtained funds from the following sources, the specific cost are also
given against them:
Source of funds Amount (`) Cost of Capital
Equity shares 30,00,000 15 percent
Preference shares 8,00,000 8 percent
Retained earnings 12,00,000 11 percent
Debentures 10,00,000 9 percent (before tax)
You are required to calculate weighted average cost of capital. Assume that Corporate tax
rate is 30 percent.

Answer :

Calculation of Weighted Average Cost of Capital (WACC)

Amount Cost of
Source of fund Weight WACC(%)
(`) Capital (%)
Equity Shares 30,00,000 0.500 15.00 7.50
Preference Shares 8,00,000 0.133 8.00 1.06
Retained Earnings 12,00,000 0.200 11.00 2.20
Debentures 10,00,000 0.167 6.30* 1.05
Total 60,00,000 1.000 11.81

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*Cost of Debentures (Kd) = Kd (before tax) × (1 – t) = 9% (1 - 0.3) = 6.30%

Question 21

Beeta Ltd. has furnished the following information:

- Earning per share (ESP) `4
- Dividend payout ratio 25%
- Market price per share ` 40
- Rate of tax 30%
- Growth rate of dividend 8%

The company wants to raise additional capital of ` 10 lakhs including debt of ` 4 lakhs. The
cost of debt (before tax) is 10% upto ` 2 lakhs and 15% beyond that.

Compute the after tax cost of equity and debt and the weighted average cost of capital.

Answer :

i. Cost of Equity Share Capital (Ke)

ii. Cost of Debt (Kd)

Interest
Kd   100   1  t 
Net Proceeds
Interest on first ` 2,00,000 @ 10% = 20,000
Interest on next ` 2,00,000 @ 15% = 30,000
50, 000
Kd    1  0.3  = 0.0875 or 8.75 %
4, 00, 000

iii. Weighted Average Cost of Capital (WACC)

Amount Cost of
Source of capital Weights WACC(%)
(`) Capital (%)
Equity Shares 6,00,000 0.60 10.70 6.42
Debt 4,00,000 0.40 8.75 3.50
Total 10,00,000 1.00 9.92

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Source : ICAI, Compilation (Old) - (From Question 22-25 )

Question 22

You are analysing the beta for ABC Computers Ltd. and have divided the company into
four broad business groups, with market values and betas for each group.
Business group Market value of equity Unleveraged beta
Main frames ` 100 billion 1.10
Personal Computers ` 100 billion 1.50
Software ` 50 billion 2.00
Printers ` 150 billion 1.00

ABC Computers Ltd. had ` 50 billion in debt outstanding.

Required:
i. Estimate the beta for ABC Computers Ltd. as a Company. Is this beta going to be equal
to the beta estimated by regressing past returns on ABC Computers stock against
a market index. Why or why not?
[Part (i) is out of syllabus and this topic is covered in Final Level paper]
ii. If the treasury bond rate is 7.5%, estimate the cost of equity for ABC Computers
Ltd. Estimate the cost of equity for each division. Which cost of equity would you use
to value the printer division? The average market risk premium is 8.5%.

Answer :

i. Beta of ABC Computers

= 1.10  2/8 + 1.502/8 + 21/8 + 13/8 = 1.275
Beta coefficient is a measure of volatility of securities return relative to the returns of
a broad based market portfolio. Hence beta measures volatility of ABC Computers
stock return against broad based market portfolio. In this case we are considering
four business groups in computer segment and not a broad based market portfolio ,
therefore beta calculations will not be the same.

ii. Cost of equity

= rf + av mkt risk premium β
= 7.5% + 1.275  8.5% = 18.34%
Main frame KE = 7.5% + 1.10  8.5% = 16.85%
Personal KE = 7.5% + 1.5  8.5% = 20.25%
Computers
Software KE = 7.5% + 2  8.5% = 24.5%
Printers KE = 7.5% + 1  8.5% = 16%
Advise: To value printer division, the use of 16% KE is recommended.

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Question 23

Z Ltd.’s operating income (before interest and tax) is ` 9,00,000. The firm’s cost of debt is 10
per cent and currently firm employs ` 30,00,000 of debt. The overall cost of capital of firm
is 12 per cent.

Required:
Calculate cost of equity.

Answer :

Calculation of Cost of Equity

EBIT
Calculation of value of firm (v) =
Overall cost of capital  K o 
9,00,000
= `75, 00, 000
0.12
Market value of equity (S) = V – Debts
= 75,00,000 - 30,00,000 = ` 45,00,000
Market value of debts (D) = 30,00,000

= 0.20 - .067 = .133  100

Ke = 13.3%.

Question 24

RES Ltd. is an all equity financed company with a market value of ` 25,00,000 and
cost of equity Ke = 21%. The company wants to buyback equity shares worth ` 5,00,000 by
issuing and raising 15% perpetual debt of the same amount. Rate of tax may be taken as
30%. After the capital restructuring and applying MM Model (with taxes), you are required
to calculate:
i. Market value of RES Ltd.
ii. Cost of Equity Ke
iii. Weighted average cost of capital and comment on it.

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Answer :

Computation of Market Value, Cost of Equity and WACC of RES Ltd.

Market Value of Equity = 25,00,000
Ke =21%
Net income (NI) for equity - holders
= Market Value of Equity
Ke
Net income (NI) for equity holders
 25,00,000
0.21
Net income for equity holders = 5,25,000
EBIT= 5,25,000/0.7= 7,50,000
All Equity Debt and Equity
EBIT 7,50,000 7,50,000
Interest to debt-holders - 75,000
EBT 7,50,000 6,75,000
Taxes (30%) 2,25,000 2,02,500
Income available to equity shareholders 5,25,000 4,72,500
Income to debt holders plus income available
5,25,000 5,47,500
to shareholders

Present value of tax-shield benefits = ` 5,00,000  0.30 = 1,50,000

i. Value of Restructured firm

= 25,00,000 + 1,50,000 = 26,50,000

ii. Cost of Equity (Ke)

Total Value = 26,50,000
Less: Value of Debt = 5,00,000
Value of Equity = 21,50,000
4,72,500
Ke   0.219 = 22%
21,50,000

iii. WACC
Cost of Debt (after tax)= 15% (1- 0.3)= 0.15 (0.70) = 0.105= 10.5%
Components of Costs Amount Cost of Capital Weight Weighted COC
Equity 21,50,000 0.22 0.81 0.178
Debt 5,00,000 0.105 0.19 0.020
26,50,000 0.198
WACC = 19.8%

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Comment: At present the company is all equity financed. So, Ke = Ko i.e. 21%. However
after restructuring, the Ko would be reduced to 19.81% and Ke would increase from 21% to
21.98%. Reduction in Ko and increase in Ke is good for the health of the company.

Question 25

Alpha Limited requires funds amounting to ` 80 lakhs for its new project. To raise the
funds, the company has following two alternatives:
i. to issue Equity Shares (at par) amounting to ` 60 lakhs and borrow the balance amount
at the interest of 12% p.a.; or
ii. to issue Equity Shares (at par) and 12% Debentures in equal proportion.
The Income-tax rate is 30%.
Find out the point of indifference between the available two modes of financing
and state which option will be beneficial in different situations.

Answer :

i. Note : The par value of equity share is assumed to be `100)

Amount = ` 80 Lakhs
Plan I = Equity of ` 60 lakhs + Debt of ` 20 lakhs
Plan II = Equity of ` 40 lakhs + Debentures of ` 40 Lakhs.
Plan I: Interest Payable on Loan
= 0.12 x 20,00,000 = 2,40,000
Plan II: Interest Payable on Debentures
= 0.12 x 40,00,000 = 4,80,000
Computation of Point of Indifference

2 (EBIT – 2,40,000) = 3(EBIT – 4,80,000)

2 EBIT – 4,80,000 = 3 EBIT – 14,40,000
2 EBIT – 3 EBIT = -14,40,000 + 4,80,000
EBIT = 9,60,000

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ii. Earnings per share (EPS) under Two Situations for both the Plans
Situation A (EBIT is assumed to be ` 9,50,000)
Particulars Plan I Plan II
EBIT 9,50,000 9,50,000
Less: Interest @ 12% 2,40,000 4,80,000
EBT 7,10,000 4,70,000
Less: Taxes @ 30% 2,13,000 1,41,000
EAT 4,97,000 3,29,000
No. of Equity Shares 60,000 40,000
EPS 8.28 8.23

Comment: In Situation A, when expected EBIT is less than the EBIT at indifference point
then, Plan I is more viable as it has higher EPS. The advantage of EPS would be
available from the use of equity capital and not debt capital.

Situation B (EBIT is assumed to be ` 9,70,000)

Particulars Plan I Plan II
EBIT 9,70,000 9,70,000
Less: Interest @ 12% 2,40,000 4,80,000
EBT 7,30,000 4,90,000
Less: Taxes @ 30% 2,19,000 1,47,000
EAT 5,11,000 3,43,000
No. of Equity Shares 60,000 40,000
EPS 8.52 8.58

Comment: In Situation B, when expected EBIT is more than the EBIT at indifference
point then, Plan II is more viable as it has higher EPS. The use of fixed-cost source of funds
would be beneficial from the EPS viewpoint. In this case, financial leverage would be
favourable.

(Note: The problem can also be worked out assuming any other figure of EBIT which is
more than 9,60,000 and any other figure less than 9,60,000. Alternatively, the
answer may also be based on the factors/ principles governing the capital structure like the
cost, risk, control, etc.).

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 OTHER PROBLEMS

Question 1

Navya Limited wishes to raise additional capital of `10 lakhs for meeting its modernisation
plan. It has ` 3,00,000 in the form of retained earnings available for investments purposes.
The following are the further details:
Debt/ equity mix 40%/60%
Cost of debt (before tax)
Upto ` 1,80,000 10%
Beyond ` 1,80,000 16%
Earnings per share `4
Dividend pay out `2
Expected growth rate in dividend 10%
Current market price per share 44
Tax rate 50%

Required:
i. To determine the pattern for raising the additional finance.
ii. To calculate the post-tax average cost of additional debt.
iii. To calculate the cost of retained earnings and cost of equity, and
iv. To determine the overall weighted average cost of capital (after tax).
Source : ICAI, RTP May 2018 (New)
Answer :

i. Pattern of Raising Additional Finance

Equity = 10,00,000 × 60/100 = ` 6,00,000
Debt = 10,00,000 × 40/100 = ` 4,00,000
Capital structure after Raising Additional Finance

Sources of fund Amount (`)

Shareholder’s funds
Equity capital (6,00,000 – 3,00,000) 3,00,000
Retained earnings 3,00,000
Debt at 10% p.a. 1,80,000
Debt at 16% p.a. (4,00,000 −1,80,000) 2,20,000
Total funds 10,00,000

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ii. Post-tax Average Cost of Additional Debt

Kd = I(1 – t), where ‘Kd’ is cost of debt, ‘I’ is interest and ‘t’ is tax rate.
On ` 1,80,000 = 10% (1 - 0.5) = 5% or 0.05
On ` 2,20,000 = 16% (1 – 0.5) = 8% or 0.08
Average Cost of Debt (Post tax) i.e.
(1,80,000 × 0.05) + (2,20,000 × 0.08)
Kd  ×100 = 6.65%
4,00,000

iii. Cost of Retained Earnings and Cost of Equity applying Dividend Growth Model

iv. Overall Weighted Average Cost of Capital (WACC) (After Tax)

Particulars Amount (`) Weights Cost of WACC
Capital
Equity (including retained earnings) 6,00,000 0.60 15% 9.00
Debt 4,00,000 0.40 6.65% 2.66
Total 10,00,000 1.00 11.66

Question 2

M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company
is presently considering several alternative investment proposals costing less than ` 20
lakhs. The corporation always raises the required funds without disturbing its present debt
equity ratio.
The cost of raising the debt and equity are as under:
Project cost Cost of debt Cost of equity
Upto ` 2 lakhs 10% 12%
Above ` 2 lakhs & upto to ` 5 lakhs 11% 13%
Above ` 5 lakhs & upto `10 lakhs 12% 14%
Above `10 lakhs & upto ` 20 lakhs 13% 14.5%
Assuming the tax rate at 50%, calculate:
i. Cost of capital of two projects X and Y whose fund requirements are ` 6.5 lakhs and
` 14 lakhs respectively.
ii. If a project is expected to give after tax return of 10%, determine under what
conditions it would be acceptable? Source : ICAI, RTP November 2018 (New)

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Answer :

i. Statement of Weighted Average Cost of Capital

Project cost Financing Proportion of After tax cost (1– Weighted
capital Tax 50%) average cost (%)
Structure
Upto ` 2 Lakhs Debt 0.4 10% (1 – 0.5) = 5% 0.4 × 5 = 2.0
Equity 0.6 12% 0.6 × 12 = 7.2
9.2%
Above ` 2 lakhs
& upto to ` 5 Debt 0.4 11% (1 – 0.5) = 5.5% 0.4 × 5.5 = 2.2
Lakhs
Equity 0.6 13% 0.6 × 13 = 7.8
10.0%
Above ` 5 lakhs
& upto ` 10 Debt 0.4 12% (1 – 0.5) = 6% 0.4 × 6 = 2.4
lakhs
Equity 0.6 14% 0.6 × 14 = 8.4
10.8%
Above ` 10
lakhs & upto ` Debt 0.4 13% (1 – 0.5) = 6.5% 0.4 × 6.5 = 2.6
20 lakhs
Equity 0.6 14.5% 0.6 × 14.5 = 8.7
11.3%

Project Fund requirement Cost of capital

X `6.5 lakhs 10.8% (from the above table)
Y `14 lakhs 11.3% (from the above table)

ii. If a Project is expected to give after tax return of 10%, it would be acceptable
provided its project cost does not exceed ` 5 lakhs or, after tax return should be more
than or at least equal to the weighted average cost of capital.

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Question 3

Company XYZ is unlevered and has a cost of equity of 20 percent and a total
market value of `10,00,00,000. Company ABC is identical to XYZ in all respects except
that it uses debt finance in its capital structure with a market value of `4,00,00,000 and a
cost of 10 percent. Find the market value of equity, weighted average cost of capital and
cost of equity of ABC if the tax advantage of debt is 25 percent.
Source : ICAI, RTP November 2013 (Old)
Answer :

Computation of Market Value of Equity of Company ABC

Total market value of company ABC

VABC =VXYZ + Bt………….(i)

Where,
VABC = Market value of leveraged company.
VXYZ = Market value of unleveraged company.
B = Market value of debt.
t = Tax rate.
Now, given
Vxyz = `10,00,00,000
B = `4,00,00,000
t = 25%
By substituting values in equation (i) above, we have
VABC = `10,00,00,000 + `4,00,00,000 × 0.25%
= `11,00,00,000
The market value of equity (s) of company ABC,
= `11,00,00,000 – `4,00,00,000
= `7,00,00,000

Weighted Average Cost of Capital of Company ABC

WACCABC = WACCXYZ[1- Bt/VABC]
 4, 00, 00, 000 
= 20% 1   0.25  = 18.18%
 11,00,00,000 
Where,
WACCABC is the weighted average cost of capital of the levered company ABC
WACCXYZ is the weighted average cost of capital of the unlevered company XYZ.

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Cost of Equity of Company ABC

REabc = RExyz+ [(1 - t)B/E(RExyz- RB)]
= 20%+[(1-.25)400,00,000/700,00,000(.20-.10)]
= 24.28% approx.
Where,
REABC is the cost of equity in the levered company ABC.
RExyz is the cost of equity in the unlevered company XYZ.
E is the market value of equity.
B is the market value of debt.

Question 4

XYZ Ltd. is currently earning a profit after tax of `25,00,000 and its shares are quoted in the
market at `450 per share. The company has 1,00,000 shares outstanding and has not
debt in its capital structure. It is expected that the same level of earnings will be
maintained for future years also. The company has 100 per cent pay-out policy.

Required:
i. Calculated the Cost of equity
ii. If the company’s pay-out ratio is assumed to be 70% and it earns 20% rate of return on
its investment, then what would be the firm’s cost of equity?
Source : ICAI, RTP May 2017 (Old)
Answer :

i. Since, the earnings for the company will remain same for future years and the pay- out
ratio is 100 per cent too. It indicates that the dividend is equal to earnings per share and
growth rate is zero per cent.
Earnings per share (EPS)
Therefore, the Cost of equity (Ke) =
Market price per share (P0 )
Earnings available to shareholders ` 25,00,000
Where, EPS =   ` 25
No. of shares outstanding ` 1,00,000
and P0 = `450
` 25
Therefore, Ke = = 0.055 or 5.55%
` 450

ii. In this case pay-out ratio is 70% and the earning rate on investment is 20%, which means
the amount retained after payment of dividend can be invested to earn an interest
of 20% p.a.
Earningsper share (EPS)  payout ratio
The Cost of Equity (Ke) =  growth rate
Market price per share (P0 )
` 25  70%
=   30%  20%
` 450
` 17.5
=  0.06  0.0988 or 9.89%
` 450
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 THEORETICAL QUESTIONS

Question 1

What is meant by weighted average cost of capital? Illustrate with an example.

Source : ICAI, PM (Old)
Answer :

Meaning of Weighted Average Cost of Capital (WACC) and an Example: The composite
or overall cost of capital of a firm is the weighted average of the costs of the various sources
of funds. Weights are taken to be in the proportion of each source of fund in the capital
structure. While making financial decisions this overall or weighted cost is used.
Each investment is financed from a pool of funds which represents the various sources
from which funds have been raised. Any decision of investment, therefore, has to be made
with reference to the overall cost of capital and not with reference to the cost of a specific
source of fund used in the investment decision.

The weighted average cost of capital is calculated by:

i. Calculating the cost of specific source of fund e.g. cost of debt, equity etc;
ii. Multiplying the cost of each source by its proportion in capital structure; and
iii. Adding the weighted component cost to get the firm’s WACC represented by K 0.
K0 = K1 W1 + K2 W2 + ………..
Where,
K1, K2 are component costs and W1, W2 are weights.

Example of WACC
Capital structure of a firm is given as under:
Equity Capital 5,00,000
Reserves 2,00,000
Debt 3,00,000
10,00,000
The component costs (before tax) are: Equity Capital 18% and Debt 10%.
Tax Rate is 35%. WACC is required to be computed.
Cost of Debt = 10% (1 − 0.35) = 6.5%
Cost of Retained Earnings is taken to be same as cost of equity.

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Computation of WACC
Source Proportion After- tax Cost WACC
Equity Capital 0.50 0.18 0.09
Retained Earnings 0.20 0.18 0.036
Debt 0.30 0.065 0.0195
0.1455

Weighted Average Cost of Capital = 14.55%.

(Note: The above example is just illustrative in nature.)

Question 2

Discuss the dividend-price approach, and earnings price approach to estimate cost of
equity capital.
Source : ICAI, PM (Old)
Answer :

In dividend price approach, cost of equity capital is computed by dividing the current
dividend by average market price per share. This ratio expresses the cost of equity capital
in relation to what yield the company should pay to attract investors. It is computed as:
D
Ke  1
P0
Where,
D1 = Dividend per share in period 1
P0 = Market price per share today

Whereas, on the other hand, the advocates of earnings price approach co-relate the earnings
of the company with the market price of its share. Accordingly, the cost of ordinary share
capital would be based upon the expected rate of earnings of a company. This approach is
similar to dividend price approach, only it seeks to nullify the effect of changes in dividend
policy.

Question 3

Describe the term “coupon rate” as applicable in debenture shares?

Source : ICAI, RTP November 2013 (Old)
Answer :

The coupon rate as in debenture shares gives the annual interest based on the nominal
value of the debenture shares.

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Question 4

Assuming that the market interest rates remain unchanged, an increase in the
coupon rate of a bond will have what effect on its selling price?
Source : ICAI, RTP November 2013 (Old)
Answer :

If the market interest rates remain unchanged, the yield to maturity will also remain
unchanged. If the coupon rate increases, the annual interest payment will increase.
Therefore, in order for the yield to remain unchanged, the selling price of the bond must
increase.

Question 5

Should companies use their weighted average cost of capital (WACC) as the
discount rate when assessing the acceptability of new projects?
Source : ICAI, RTP May 2014 (Old)
Answer :

When we mention the WACC in this context, we can assume we are talking about an
historic WACC, i.e. one referring to the cost of funds already raised. There are certain
conditions that must be met in order for it to be appropriate to use an historic cost of capital
to appraise new projects, as follows:
 The new project must have a similar level of risk to the average risk of a
company’s existing projects;
 The amount of finance needed for the new project must be small relative to the amount
of finance already raised.
 The company must be intending to finance the new project by using a similar financing
mix to its historical financing mix.

Question 6

The overall cost of capital can be reduced by increasing the debt portion in the
capital structure. Discuss.
Source : ICAI, RTP November 2014 (Old)
Answer :

"The overall cost of capital can be reduced by increasing the debt portion in the
capital structure”

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In a zero-tax environment, MM Hypothesis has proved that the overall cost of

capital is independent of the amount of leverage in the capital structure. However, when
companies are subject to tax, the overall cost of capital will be reduced due to the tax shield
provided by debt.

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 Chapter
FINANCING DECISIONS
5 - CAPITAL STRUCTURE

LEARNING OUTCOMES
 State the meaning and significance of capital structure.
 Discuss the various capital structure theories i.e. Net Income Approach, Traditional
Approach, Net Operating Income (NOI) Approach, Modigliani and Miller (MM)
Approach, Trade- off Theory and Pecking Order Theory.
 Describe concepts and factors for designing an optimal capital structure.
 Discuss essential features of capital structure of an entity.
 Discuss optimal capital structure.
 Analyse the relationship between the performance of a company and its impact
on the earnings of the shareholders i.e. EBIT-EPS analysis.
 Discuss the meaning, causes and consequences of over and under capitalisation to an
entity.

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CHAPTER OVERVIEW

CAPITAL STRUCTURE DECISION

Capital Structure Theories Designing an Optimal Capital Structure

 Net Income (NI) Approach

 Traditional Approach
 Net Operating Income (NOI)
Approach
 Modigliani- Miller (MM)
 Approach
 Trade-off Theory
Pecking Order Theory

EBIT- EPS Analysis

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SUMMARY

 Capital Structure: Capital structure refers to the mix of a firm’s capitalisation (i.e.
mix of long term sources of funds such as debentures, preference share capital,
equity share capital and retained earnings for meeting total capital requirement).
While choosing a suitable financing pattern, certain factors like cost, risk, control,
flexibility and other considerations like nature of industry, competition in the
industry etc. should be considered
 Capital Structure Theories: The following approaches explain the relationship
between cost of capital, capital structure and value of the firm:
Net income approach
Net operating income approach
Modigliani-Miller approach
Traditional approach
Trade-off Theory
Pecking Order Theory
 Optimal Capital Structure (EBIT-EPS Analysis): The basic objective of financial
management is to design an appropriate capital structure which can provide the
highest earnings per share (EPS) over the firm’s expected range of earnings before
interest and taxes (EBIT). PS measures a firm’s performance for the investors.
The level of EBIT varies from year to year and represents the success of a firm’s
operations. EBIT-EPS analysis is a vital tool for designing the optimal capital
structure of a firm. The objective of this analysis is to find the EBIT level that will
equate EPS regardless of the financing plan chosen.
 Over Capitalisation : It is a situation where a firm has more capital than it
needs or in other words assets are worth less than its issued share capital, and
earnings are insufficient to pay dividend and interest.
 Under Capitalisation : It is just reverse of over-capitalisation. It is a state, when its
actual capitalization is lower than its proper capitalization as warranted by its
earning capacity

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. Which of the following statements is false in the context of explaining the concept of
capital structure of a firm:
a. It resembles the arrangements of the various parts of a building
b. It represents the relation between fixed assets and current assets
c. Combinations of various long-terms sources
d. The relation between equity and debt

2. The assumptions of M-M hypothesis of capital structure do not include the

following;
a. Capital markets are imperfect
b. Investors have homogeneous expectations
c. All firms can be classified into homogeneous risk classes
d. The dividend-payout ratio is cent percent, and there is no corporate tax

3. Which of the following is irrelevant for optimal capital structure?

a. Flexibility,
b. Solvency,
c. Liquidity,
d. Control.

4. Financial Structure refer to

a. All Financial resources,
b. Short-term funds,
c. Long-term funds
d. None of these.

5. An EBIT-EPS indifference analysis chart is used for

a. Evaluating the effects of business risk on EPS
b. Examining EPS results for alternative financial plans at varying EBIT levels
c. Determining the impact of a change in sales on EBIT
d. Showing the changes in EPS quality over time

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6. The term “capital structure” means

a. Long-term debt, preferred stock, and equity shares.
b. Current assets and current liabilities.
c. Net working capital
d. Shareholders’ equity.

7. The cost of monitoring management is considered to be a (an):

a. Bankruptcy cost.
b. Transaction cost.
c. Agency cost.
d. Institutional cost.

8. The traditional approach towards the valuation of a firm assumes:

a. That the overall capitalization rate changes in financial leverage.
b. That there is an optimum capital structure.
c. That total risk is not changed with the changes in the capital structure.
d. That markets are perfect.

9. Market values are often used in computing the weighted average cost of capital
because
a. This is the simplest way to do the calculation.
b. This is consistent with the goal of maximizing shareholder value.
c. This is required by SEBI.
d. This is a very common mistake.

10. A firm’s optimal capital structure:

a. Is the debt-equity ratio that results in the minimum possible weighted average cost
of capital.
b. 40 percent debt and 60 percent equity.
c. When the debt-equity ratio is .50.
d. When Cost of equity is minimum

ANSWERS

1. b 2. a

3. b 4. a
5. b 6. a
7. c 8. b
9. b 10. a

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 ILLUSTRATIONS

Source : ICAI, SM (New) - (From Question No. 1 - 9 )

Question 1

Rupa Ltd.'s EBIT is ` 5,00,000. The company has 10%, 20 lakh debentures. The
equity capitalization rate i.e. Ke is 16%.

You are required to calculate:

i. Market value of equity and value of firm
ii. Overall cost of capital.

Answer :

i. Statement showing value of firm

`
EBIT 5,00,000
Less: Interest on debentures (10% of ` 20,00,000) (2,00,000)
Earnings available for equity holders i.e. Net Income (NI) 3,00,000
Equity capitalization rate (Ke) 16%
NI  3, 00, 000  18,75,000
Market value of equity (S) =   100 
K e  16.00 
Market value of debt (D) 20,00,000
Total value of firm (V) = S + D 38,75,000

EBIT 5,00,000
ii. Overall cost of capital =   12.90%
Value of firm 38,75,000

Question 2

Indra Ltd. has EBIT of ` 1,00,000. The company makes use of debt and equity capital. The
firm has 10% debentures of ` 5,00,000 and the firm’s equity capitalization rate is 15%.

You are required to compute:

i. Current value of the firm
ii. Overall cost of capital.

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Answer :

i. Calculation of total value of the firm

`
EBIT 1,00,000
Less: Interest (@10% on ` 5,00,000) 50,000
Earnings available for equity holders 50,000
Equity capitalization rate i.e. Ke 15%

Earnings available for equity holders

Value of equity holders =
Value of equity (S)
50, 000
= ` 3,33,333
0.15
Value of Debt (given) D = 5,00,000
Total value of the firm V = D + S (5,00,000 + 3,33,333) = 8,33,333

S  D  EBIT
ii. Overall cost of capital = K o  K e  K e    K d   or
V V V
 3, 33, 333   5, 00, 000 
= 0.15    0.10  
 8, 33, 333   8, 33, 333 
1
=  50,000 + 50,000] = 12,00%
8, 33, 333

Question 3

Amita Ltd’s operating income is ` 5,00,000. The firm’s cost of debt is 10% and currently the
firm employs ` 15,00,000 of debt. The overall cost of capital of the firm is 15%.

You are required to determine:

i. Total value of the firm.
ii. Cost of equity.

Answer :

i. Statement showing value of the firm

`
Net operating income/EBIT 5,00,000
Less: Interest on debentures (10% of ` 15,00,000) (1,50,000)
Earnings available for equity holders 3,50,000
Total cost of capital (K0) (given) 15%
EBIT 5, 00, 000 33,33,333
Value of the firm V = 
K0 0.15

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ii. Calculation of cost of equity

`
Market value of debt (D) 15,00,000
Market value of equity (s) S = V − D = `33,33,333 – `15,00,000 18,33,333

Earnings available for equity holders

Ke =
Value of equity (S)
EBIT - Interest paid on debt ` 3,50, 000
Or, = =  19.09%
Market value of equity ` 18,33,333
Or
S D
K0 = K e    K d  
V V
V D
K0 = K 0    K d  
S S

1
= (0.15 × 33,33, 333) - 0 (0.10  15,00,0000)
18,33,333
1
= [5,00,000 - 1,50, 000] = 19.09%
18,33,333

Question 4

Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has
50 per cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per
cent equity. (All percentages are in market-value terms). The borrowing rate for both
companies is 8 per cent in a no-tax world, and capital markets are assumed to be perfect.

a. (i) If you own 2 per cent of the shares of Alpha Ltd., what is your return if the
company has net operating income of `3,60,000 and the overall capitalisation rate of the
company, K0 is 18 per cent? (ii) What is the implied required rate of return on equity?

b. Beta Ltd. has the same net operating income as Alpha Ltd. (i) What is the implied
required equity return of Beta Ltd.? (ii) Why does it differ from that of Alpha Ltd.?

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Answer :

NOI ` 3, 60, 000

a. Value of the Alpha Ltd. =   ` 20, 00, 000
K0 18%
i. Return on Shares on Alpha Ltd.
`
Value of the company 20,00,000
Market value of debt (50%) 10,00,000
Market value of shares (50%) 10,00,000

`
Net operating income 3,60,000
Interest on debt (8% × `10,00,000) 80,000
Earnings available to shareholders 2,80,000
Return on 2% shares (2% × ` 2,80,000) 5,600

` 2, 80, 000
ii. Implied required rate of return on equity = = 28%
` 10, 00, 000
b. i. Calculation of Implied rate of return
`
Total value of company 20,00,000
Market value of debt (20% × `20,00,000) 4,00,000
Market value of equity (80% × `20,00,000) 16,00,000

`
Net operating income 3,60,000
Interest on debt (8%× `4,00,000) 32,000
Earnings available to shareholders 3,28,000

` 3,28,000
Implied required rate of return on equity =  20.5%
` 16,00,000

ii. It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure.
As the equity capitalisation is a linear function of the debt-to-equity ratio when we
use the net operating income approach, the decline in required equity return offsets
exactly the disadvantage of not employing so much in the way of “cheaper” debt
funds.

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Question 5

There are two company N Ltd. and M Ltd., having same earnings before interest
and taxes i.e. EBIT of ` 20,000. M Ltd. is a levered company having a debt of `1,00,000 @
7% rate of interest. The cost of equity of N Ltd. is 10% and of M Ltd. is 11.50%.
Find out how arbitrage process will be carried on?

Answer :

Company
M Ltd. N Ltd.
EBIT (NOI) ` 20,000 ` 20,000
Debt (D) ` 1,00,000 -
Ke 11.50% 10%
Kd 7% -

NOI - Interest
Value of equity (S) =
Cost of equity
20, 000 - 7, 000
SM = = ` 1,13,043
11.50%
20, 000
SN = ` 2,00,000
10%
VM = 1,13,043 + 1,00,000 {V = S + D} = ` 2,13,043
VN = ` 2,00,000

Arbitrage Process
If you have 10% shares of M Ltd., your value of investment in equity shares is 10% of
`1,13,043 i.e. ` 11,304.30 and return will be 10% of (`20,000 – `7,000) = ` 1,300.
Alternate Strategy will be:
Sell your 10% share of levered firm for ` 11,304.30 and borrow 10% of levered firms debt i.e.
10% of ` 1,00,000 and invest the money i.e. 10% in unlevered firms stock:
Total resources /Money we have = `11,304.30 + `10,000 = `21,304.3 and you invest 10% of
`2,00,000 = ` 20,000
Surplus cash available with you is = `21,304.3 – `20,000 = ` 1,304.3
Your return = 10% EBIT of unlevered firm – Interest to be paid on borrowed funds
i.e. = 10% of ` 20,000 – 7% of ` 10,000 = `2,000 – `700 = ` 1,300
i.e. your return is same i.e. ` 1,300 which you are getting from N Ltd. before investing in M
Ltd. but still you have ` 1,304.3 excess money available with you. Hence, you are better off
by doing arbitrage.

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Question 6

There are two companies U Ltd. and L Ltd., having same NOI of `20,000 except that L Ltd.
is a levered company having a debt of `1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd.
are 10% and 18% respectively.
Show how arbitrage process will work.

Answer :

Company
U Ltd. L Ltd.
NOI ` 20,000 ` 20,000
Debt capital - ` 1,00,000
Kd - 7%
Ke 10% 18%
 EBIT  Interest  `2,00,000 ` 72,222
Value of equity capital (s) =    20, 000   20, 000  7, 000 
 Ke     
 0.10   0.18 
Total value of the firm V = S + D ` 2,00,000 ` 1,72,222
(` 72,222 +`1,00,000)

Assume you have 10% shares of unlevered firm i.e. investment of 10% of ` 2,00,000 =
`20,000 and Return @ 10% on ` 20,000. Investment will be 10% of earnings available for
equity i.e. 10% × 20,000 = ` 2,000.

Alternative strategy:
Sell your shares in unlevered firm for ` 20,000 and buy 10% shares of levered firm’s equity
plus debt
i.e. 10% equity of levered firm = 7,222
10% debt of levered firm = 10,000
Total investment = 17,222
Your resources are ` 20,000
Surplus cash available = Surplus – Investment = 20,000 – 17,222 = ` 2,778
Your return on investment is:
7% on debt of ` 10,000 = 700
10% on equity i.e. 10% of earnings available for equity holders i.e. (10% × 13,000) = 1,300
Total return = 2,000

i.e. in both the cases the return received is ` 2,000 and still you have excess cash of ` 2,778.

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Hence, you are better off i.e you will start selling unlevered company shares and buy
levered company’s shares thereby pushing down the value of shares of unlevered firm and
increasing the value of levered firm till equilibrium is reached.

Question 7

Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary
shares of `10 per share. The firm wants to raise `250,000 to finance its investments and is
considering three alternative methods of financing – (i) to issue 25,000 ordinary shares at
`10 each, (ii) to borrow `2,50,000 at 8 per cent rate of interest, (iii) to issue 2,500 preference
shares of `100 each at an 8 per cent rate of dividend. If the firm’s earnings before interest
and taxes after additional investment are `3,12,500 and the tax rate is 50 per cent, the effect
on the earnings per share under the three financing alternatives will be as follows:

Table: EPS under alternative financing favorable EBIT:

Equity Debt Preference
Particulars
Financing(`) Financing (`) Financing (`)
EBIT 3,12,000 3,12,550 3,12,550
Less: Interest 0 20,000 0
PBT 3,12,500 2,92,500 3,12,500
Less: Taxes 1,56,250 1,46,250 1,56,250
PAT 1,56,250 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earning available to ordinary 1,56,250 1,46,250 1,36,250
shareholders
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 1.25 1.46 1.36

The firm is able to maximize the earnings per share when it uses debt financing. Though
the rate of preference dividend is equal to the rate of interest, EPS is high in case of debt
financing because interest charges are tax deductible while preference dividends are not.
With increasing levels of EBIT, EPS will increase at a faster rate with a high degree
of leverage.

However, if a company is not able to earn a rate of return on its assets higher than the
interest rate (or the preference dividend rate), debt (or preference financing) will have an
adverse impact on EPS. Suppose the firm in illustration above has an EBIT of `75,000/-,
then EPS under different methods will be as follows:

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Table: EPS under alternative financing methods: Unfavourable EBIT:

Equity Debt Preference
Particulars
Financing(`) Financing (`) Financing (`)
EBIT 75,000 75,000 75,000
Less: Interest 0 20,000 0
PBT 75,000 55,000 75,000
Less: Taxes 37,000 27,500 37,500
PAT 37,500 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earning available to ordinary 1,56,250 27,500 17,500
shareholders
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 0.30 0.27 0.17

It is obvious that under unfavourable conditions, i.e. when the rate of return on the total
assets is less than the cost of debt, the earnings per share will fall with the degree of
leverage.

Question 8

Best of Luck Ltd., a profit making company, has a paid-up capital of ` 100 lakhs consisting
of 10 lakhs ordinary shares of ` 10 each. Currently, it is earning an annual pre-tax profit of `
60 lakhs. The company’s shares are listed and are quoted in the range of ` 50 to ` 80. The
management wants to diversify production and has approved a project which will cost ` 50
lakhs and which is expected to yield a pre-tax income of ` 40 lakhs per annum. To raise
this additional capital, the following options are under consideration of the management:

a. To issue equity share capital for the entire additional amount. It is expected that the new
shares (face value of ` 10) can be sold at a premium of ` 15.
b. To issue 16% non-convertible debentures of ` 100 each for the entire amount.
c. To issue equity capital for ` 25 lakhs (face value of ` 10) and 16% non-convertible
debentures for the balance amount. In this case, the company can issue shares at a
premium of ` 40 each.

You are required to advise the management as to how the additional capital can be
raised, keeping in mind that the management wants to maximise the earnings per share to
maintain its goodwill. The company is paying income tax at 50%.

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Answer :

Calculation of Earnings per share under the three options:

Particulars Options
Option I: Option II: Option III:
Issue Equity Issue 16% Issue Equity
shares only Debentures only Shares and 16%
Debentures of
equal amount
Number of Equity Shares (nos):
- Existing 10,00,000 10,00,000 10,00,000
- Newly issued 2,00,000 - 50,000
 ` 50,00,000   ` 25, 00, 000 
   
 `  10  15    ` 10  40 

Total 12,00,000 10,00,000 10,50,000

16% Debentures ` - 50,00,000 25,00,000
` ` `
Profit Before Interest and Tax:
- Existing pre-tax profit 60,00,000 60,00,000 60,00,000
- From new projects 40,00,000 40,00,000 40,00,000
1,00,00,000 1,00,00,000 1,00,00,000
Less: Interest on 16% - 8,00,000 4,00,000
Debentures (16% `50,00,000) (16%×`25,00,000)
Profit Before Tax 1,00,00,000 92,00,000 96,00,000
Tax at 50% 50,00,000 46,00,000 48,00,000
Profit After Tax 50,00,000 46,00,000 48,00,000
Earnings Per Share (EPS) 4.17 4.60 4.57
 PAT   ` 50, 00, 000   ` 46, 00, 000   ` 48, 00, 000 
   12, 00, 000   10, 00, 000   10, 50, 000 
 No. of Shares       

Advise: Option II i.e. issue of 16% Debentures is most suitable to maximize the earnings per
share.

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Question 9

Shahji Steels Limited requires ` 25,00,000 for a new plant. This plant is expected to
yield earnings before interest and taxes of ` 5,00,000. While deciding about the financial
plan, the company considers the objective of maximizing earnings per share. It has three
alternatives to finance the project - by raising debt of ` 2,50,000 or ` 10,00,000 or 15,00,000
and the balance, in each case, by issuing equity shares. The company’s share is currently
selling at ` 150, but is expected to decline to ` 125 in case the funds are borrowed in excess
of ` 10,00,000. The funds can be borrowed at the rate of 10 percent upto ` 2,50,000, at 15
percent over ` 2,50,000 and upto ` 10,00,000 and at 20 percent over ` 10,00,000. The tax rate
applicable to the company is 50 percent. Which form of financing should the company
choose?

Answer :

Plan I = Raising Debt of ` 2.5 lakh + Equity of ` 22.5 lakh.

Plan II = Raising Debt of ` 10 lakh + Equity of ` 15 lakh.
Plan III = Raising Debt of ` 15 lakh + Equity of ` 10 lakh.

Calculation of Earnings per share (EPS):

Financial Plans
Particulars
Plan I (`) Plan II (`) Plan III (`)
Expected EBIT 5,00,000 5,00,000 5,00,000
Less: Interest (a) (25,000) (1,37,500) (2,37,500)
Earnings before taxes 4,75,000 3,62,500 2,62,500
Less: Taxes @ 50% (2,37,500) (1,81,250) (1,31,250)
Earnings after taxes (EAT) 2,37,500 1,81,250 1,31,250
Number of shares (b) 15,000 10,000 8,000
Earnings per share (EPS) 15.83 18.13 16.41

Financing Plan II (i.e. Raising debt of `10 lakh and issue of equity share capital of `15 lakh)
is the option which maximises the earnings per share.

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Working Notes:

a. Calculation of interest on Debt.

Plan I (`2,50,000 x10%) ` 25,000
Plan II (`2,50,000 x 10%) ` 25,000
(`7,50,000 x 15%) `1,12,500 `1,37,500
Plan III (`2,50,000 x 10%) ` 25,000
(`7,50,000 x 15%) `1,12,500
(`5,00,000 x 20%) `1,00,000 `2,37,500

b. Number of equity shares to be issued

` 22,50,000
Plan I = =15,000 shares
` 150 (Market price of share)

` 15,00,000
Plan II =  10,000 shares
` 150
` 10,00,000
Plan III =  8,000 shares
` 125

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 PRACTICE QUESTIONS

Source : ICAI, SM (New) - (From Question No. 1 - 5 )

Question 1

Ganesha Limited is setting up a project with a capital outlay of ` 60,00,000. It has two
alternatives in financing the project cost.
Alternative-I : 100% equity finance by issuing equity shares of ` 10 each
Alternative-II : Debt-equity ratio 2:1 (issuing equity shares of ` 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%.
Calculate the indifference point between the two alternative methods of financing.

Answer :

Calculation of Indifference point between the two alternatives of financing

Alternative-I By issue of 6,00,000 equity shares of `10 each amounting to `60 lakhs. No
financial charges are involved.

Alternative-II By raising the funds in the following way:

Debt = ` 40 lakhs
Equity = ` 20 lakhs (2,00,000 equity shares of `10 each)

18
Interest payable on debt = ` 40, 00, 000   `7, 20, 000
100
The difference point between the two alternatives is calculated by:
 EBIT  I 1  1  T    EBIT  I 2  1  T 
E1 E2
Where,
EBIT = Earnings before interest and taxes
I1 = Interest charges in Alternative-I
I2 = Interest charges in Alternative-II
T = Tax rate
E1 = No. of Equity shares in Alternative-I
E2 = No. of Equity shares in Alternative-II
Putting the values, the break-even point would be as follows:

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(EBIT - 0) (1 - 0.40) (EBIT - 7,20,000) (1 - 0.40)


6,00,000 2,00,000
(EBIT) (0.60) (EBIT - 7,20,000) (0.60)

6,00,000 2,00,000
EBIT (0.60) 0.60 (EBIT - 7,20,000)

3 1
EBIT = 3EBIT-21,60,000
-2 EBIT = -21,60,000
21,60,000
EBIT =
2
EBIT = `10,80,000
Therefore, at EBIT of `10,80,000 earnings per share for the two alternatives is equal.

Question 2

Ganapati Limited is considering three financing plans. The key information is as follows:
a. Total investment to be raised ` 2,00,000
b. Plans of Financing Proportion:

Plans Equity Debt Preference Shares

A 100% - -
B 50% 50% -
C 50% - 50%

c. Cost of debt 8%
Cost of preference shares 8%
d. Tax rate 50%
e. Equity shares of the face value of ` 10 each will be issued at a premium of ` 10 per share.
f. Expected EBIT is ` 80,000.

You are required to determine for each plan: -

i. Earnings per share (EPS)
ii. The financial break-even point.
iii. Indicate if any of the plans dominate and compute the EBIT range among the plans for
indifference.

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Answer :

i. Computation of Earnings per share (EPS)

Plans A B C
Earnings before interest and tax 80,000 80,000 80,000
(EBIT)
Less: Interest charges -- (8,000) --
(8% × `1 lakh)
Earnings before tax (EBT) 80,000 72,000 80,000
Less: Tax (@ 50%) (40,000) (36,000) (40,000)
Earnings after tax (EAT) 40,000 36,000 40,000
Less: Preference Dividend -- -- (8,000)
(8% × `1 lakh)
Earnings available for Equity 40,000 36,000 32,000
shareholders (A)
No. of Equity shares (B) 10,000 5,000 5,000
(`2 lakh ÷ `20) (`1 lakh ÷ `20) (`1 lakh ÷ `20)
EPS ` [(A) ÷ (B)] 4 7.20 6.40

ii. Calculation of Financial Break-even point

Financial break-even point is the earnings which are equal to the fixed finance charges
and preference dividend.
Plan A : Under this plan there is no interest or preference dividend payment
hence, the Financial Break-even point will be zero.
Plan B : Under this plan there is an interest payment of `8,000 and no preference
dividend, hence, the Financial Break-even point will be `8,000 (Interest charges).
Plan C : Under this plan there is no interest payment but an after tax preference
dividend of `8,000 is paid. Hence, the Financial Break-even point will be before
tax earnings of `16,000 (i.e. `8,000 ÷ 0.5 = `16,000.)

iii. Computation of indifference point between the plans.

The indifference between two alternative methods of financing is calculated by applying
the following formula.
 EBIT  I 1  1  T    EBIT  I 2  1  T 
E1 E2
Where,
EBIT = Earnings before interest and tax.
I1 = Fixed charges (interest or pref. dividend) under Alternative
I2 = Fixed charges (interest or pref. dividend) under Alternative
T = Tax rate
E1 = No. of equity shares in Alternative 1
E2 = No. of equity shares in Alternative 2
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Now, we can calculate indifference point between different plans of financing.

i. Indifference point where EBIT of Plan A and Plan B is equal.

 EBIT  0  1  0.5  (EBIT - 8, 000) (1 - 0.5)
10, 000 5, 000
0.5 EBIT (5,000) = (0.5 EBIT – 4,000) (10,000)
0.5 EBIT = EBIT – 8,000
0.5 EBIT = 8,000
EBIT = `16,000

ii. Indifference point where EBIT of Plan A and Plan C is equal.

 EBIT  0  1  0.5  (EBIT - 0) (1 - 0.5) - 8,000
10, 000 5, 000
0.5 EBIT 0.5 EBIT - 8,000
10, 000 5, 000
0.25 EBIT = 0.5 EBIT – 8,000
0.25 EBIT = 8,000
EBIT = ` 32,000

iii. Indifference point where EBIT of Plan B and Plan C is equal.

 EBIT  8, 000  1  0.5  (EBIT - 0)(1 - 0.5) - 8,000
5, 000 5, 000
0.5 EBIT – 4,000 = 0.5 EBIT – 8,000
There is no indifference point between the financial plans B and C.
It can be seen that Financial Plan B dominates Plan C. Since, the financial break even
point of the former is only `8,000 but in case of latter it is `16,000.

Question 3

Yoyo Limited presently has `36,00,000 in debt outstanding bearing an interest rate of
10 per cent. It wishes to finance a `40,00,000 expansion programme and is considering three
alternatives: additional debt at 12 per cent interest, preference shares with an 11 per cent
dividend, and the issue of equity shares at `16 per share. The company presently has
8,00,000 shares outstanding and is in a 40 per cent tax bracket.
a. If earnings before interest and taxes are presently `15,00,000, what would be earnings
per share for the three alternatives, assuming no immediate increase in profitability?
b. Develop an indifference chart for these alternatives. What are the approximate
indifference points? To check one of these points, what is the indifference point
mathematically between debt and common?

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c. Which alternative do you prefer? How much would EBIT need to increase before the
next alternative would be best?

Answer :

a.
Alternatives
Alternative–I : Alternative- II: Alternative- III:
Take additional Issue 11% Issue further
Particulars
Debt Preference Equity Shares
Shares
(`) (`) (`)
EBIT 15,00,000 15,00,000 15,00,000
Interest on Debts:
– on existing debt @10% (3,60,000) (3,60,000) (3,60,000)
– on new debt @ 12% (4,80,000) -- --
Profit before taxes 6,60,000 11,40,000 11,40,000
Taxes @ 40% (2,64,000) (4,56,000) (4,56,000)
Profit after taxes 3,96,000 6,84,000 6,84,000
Preference shares -- (4,40,000) --
Earnings available to equity 3,96,000 2,44,000 6,84,000
Shareholders
Number of shares 8,00,000 8,00,000 10,50,000
Earnings per share 0.495 0.305 0.651

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 FINANCING DECISIONS- CAPITAL STRUCTURE

b. Approximate indifference points: Debt and equity shares, `24 lakhs, preference
and equity shares, `33 lakhs in EBIT; Debt dominates preferred by the same margin
throughout, there is no difference point. Mathematically, the indifference point between
debt and equity shares is (in thousands):
EBIT * - ` 840 EBIT * - ` 360
800 1, 050
EBIT* (1,050) – ` 840(1,050) = EBIT* (800) – `360 (800)
250EBIT* = `5,94,000
EBIT* = `2,376
Note that for the debt alternative, the total before-tax interest is `840, and this is the
intercept on the horizontal axis. For the preferred stock alternative, we divide `440 by
(1-0.40) to get `733. When this is added to `360 in interest on existing debt, the intercept
becomes `1,093.

c. For the present EBIT level, equity shares are clearly preferable. EBIT would need
to increase by `2,376 -`1,500 = `876 before an indifference point with debt is reached.
One would want to be comfortably above this indifference point before a strong case for
debt should be made. The lower the probability that actual EBIT will fall below the
indifference point, the stronger the case that can be made for debt, all other things
remain the same.

Question 4

Alpha Limited requires funds amounting to `80 lakh for its new project. To raise the funds,
the company has following two alternatives:
i. To issue Equity Shares of `100 each (at par) amounting to `60 lakh and borrow the
balance amount at the interest of 12% p.a.; or
ii. To issue Equity Shares of `100 each (at par) and 12% Debentures in equal proportion.
The Income-tax rate is 30%.
Find out the point of indifference between the available two modes of financing and state
which option will be beneficial in different situations.

Answer :

i. Amount = `80,00,000
Plan I = Equity of `60,00,000 + Debt of `20,00,000
Plan II = Equity of `40,00,000 + 12% Debentures of `40,00,000

Plan I : Interest Payable on Loan

= 12% × `20,00,000 = `2,40,000
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Plan II: Interest Payable on Debentures

= 12% × `40,00,000 = `4,80,000

Computation of Point of Indifference

 EBIT  I 1  1  T    EBIT  I 2  1  T 
E1 E2
(EBIT - ` 2,40,000) (1- 0.3) (EBIT - ` 4,48,000) (1 - 0.3)

60, 000 40, 000
2 (EBIT – `2,40,000) = 3 (EBIT – `4,80,000)
2 EBIT – `4,80,000 = 3 EBIT – `14,40,000
2 EBIT – 3 EBIT = - `14,40,000 + `4,80,000
EBIT = `9,60,000

ii. Earnings per share (EPS) under Two Situations for both the Plans
Situation A (EBIT is assumed to be ` 9,50,000)
Particulars Plan I Plan II
EBIT 9,50,000 9,50,000
Less: Interest @ 12% (2,40,000) (4,80,000)
EBT 7,10,000 4,70,000
Less: Taxes @ 30% (2,13,000) (1,41,000)
EAT 4,97,000 3,29,000
No. of Equity Shares 60,000 40,000
EPS 8.28 8.23

Comment: In Situation A, when expected EBIT is less than the EBIT at indifference
point then, Plan I is more viable as it has higher EPS. The advantage of EPS would be
available from the use of equity capital and not debt capital.

Situation A (EBIT is assumed to be ` 9,70,000)

Particulars Plan I Plan II
EBIT 9,70,000 9,70,000
Less: Interest @ 12% (2,40,000) (4,80,000)
EBT 7,30,000 4,90,000
Less: Taxes @ 30% (2,19,000) (1,47,000)
EAT 5,11,000 3,43,000
No. of Equity Shares 60,000 40,000
EPS 8.52 8.58

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Comment: In Situation B, when expected EBIT is more than the EBIT at

indifference point then, Plan II is more viable as it has higher EPS. The use of fixed-cost
source of funds would be beneficial from the EPS viewpoint. In this case, financial
leverage would be favourable.

(Note: The problem can also be worked out assuming any other figure of EBIT
which is more than 9,60,000 and any other figure less than 9,60,000. Alternatively,
the answer may also be based on the factors/governing the capital structure like
the cost, risk, control, etc. Principles).

Question 5

One-third of the total market value of Sanghmani Limited consists of loan stock, which has
a cost of 10 per cent. Another company, Samsui Limited, is identical in every respect to
Sanghmani Limited, except that its capital structure is all-equity, and its cost of equity is
16 per cent. According to Modigliani and Miller, if we ignored taxation and tax relief
on debt capital, what would be the cost of equity of Sanghmani Limited?

Answer :

Here we are assuming that MM Approach 1958: Without tax, where capital structure
has no relevance with the value of company and accordingly overall cost of capital of both
levered as well as unlevered company is same. Therefore, the two companies should have
similar WACCs. Because Samsui Limited is all-equity financed, its WACC is the same as
its cost of equity finance, i.e. 16 per cent. It follows that Sanghmani Limited should
have WACC equal to 16 per cent also.
Therefore, Cost of equity in Sanghmani Ltd. (levered company) will be calculated as
follows:
2 1
K o   K e   K d = 16% (i.e. equal to WACC of Samsui Ltd.)
3 3
2 1
Or, 16% =   K e  
3 3
Or, Ke = 19
Source : ICAI, Compilation (Old) - (From Question No. 6 - 11 )
Question 6

D Ltd. is foreseeing a growth rate of 12% per annum in the next two years. The growth rate
is likely to be 10% for the third and fourth year. After that the growth rate is expected to
stabilise at 8% per annum. If the last dividend was ` 1.50 per share and the investor’s
required rate of return is 16%, determine the current value of equity share of the company.
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The P.V. factors at 16%

Year 1 2 3 4
P.V. Factor .862 .743 .641 .552

Answer :

The current value of equity share of D Ltd. is sum of the following:

i. Presently value (PV) of dividends payments during 1-4 years; and
ii. Present value (PV) of expected market price at the end of the fourth year based
on constant growth rate of 8 per cent.

PV of dividends – year 1-4

Year Dividend PV factor at 16% Total PV (in `)
1 1.50(1 + 0.12)=1.68 0.862 1.45
2 1.68 (1+0.12)= 1.88 0.743 1.40
3 1.88 (1 + 0.10)=2.07 0.641 1.33
4 2.07 (1 + 0.10)= 2.28 0.552 1.26
Total 5.44

Present value of the market price (P4 ): end of the fourth year –
P4 = D5 / (Ke-g) = ` 2.28 (1.08) / (16% - 8%) = ` 30.78
PV of ` 30.78 = ` 30.78 0.552 = ` 16.99

Hence,
Value of equity shares ` 5.44 + ` 16.99 = ` 22.43

Question 7

A Company needs ` 31,25,000 for the construction of new plant. The following three plans
are feasible
I. The Company may issue 3,12,500 equity shares at ` 10 per share.
II. The Company may issue 1,56,250 ordinary equity shares at ` 10 per share and 15,625
debentures of Rs,. 100 denomination bearing a 8% rate of interest.
[Link] Company may issue 1,56,250 equity shares at ` 10 per share and 15,625
preference shares at ` 100 epr share bearing a 8% rate of dividend.
i. if the Company's earnings before interest and taxes are ` 62,500, ` 1,25,000, `
2,50,000, ` 3,75,000 and ` 6,25,000, what are the earnings per share under
each of three financial plans ? Assume a Corporate Income tax rate of 40%.
ii. Which alternative would you recommend and why?

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iii. Determine the EBIT-EPS indifference points by formulae between Financing Plan I
and Plan II and Plan I and Plan III.

Answer :

i. Computation of EPS under three-financial plans.

Plan I: Equity Financing
EBIT ` 62,500 ` 1,25,000 ` 2,50,000 ` 3,75,000 ` 6,25,000
Interest 0 0 0 0 0
EBT ` 62,500 ` 1,25,000 ` 2,50,000 ` 3,75,000 ` 6,25,000
Less: Taxes 40% 25,000 50,000 1,00,000 1,50,000 2,50,000
PAT ` 37,500 ` 75,000 ` 1,50,000 ` 2,25,000 ` 3,75,000
No. of equity shares 3,12,500 3,12,500 3,12,500 3,12,500 3,12,500
EPS ` 0.12 0.24 0.48 0.72 1.20

Plan II: Debt – Equity Mix

EBIT ` 62,500 ` 1,25,000 ` 2,50,000 ` 3,75,000 ` 6,25,000
Less : Interest 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
EBT (62,500) 0 1,25,000 2,50,000 5,00,000
Less: Taxes 40% 25,000* 0 50,000 1,00,000 2,00,000
PAT (37,500) 0 75,000 1,50,000 3,00,000
No. of equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (` 0.24) 0 0.48 0.96 1.92

* The Company will be able to set off losses against other profits. If the Company has
no profits from operations, losses will be carried forward.

Plan III : Preference Shares – Equity Mix

EBIT ` 62,500 ` 1,25,000 ` 2,50,000 ` 3,75,000 ` 6,25,000
Less : Interest 0 0 0 0 0
EBT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Taxes 40% 25,000 50,000 1,00,000 1,50,000 2,50,000
PAT 37,500 75,000 1,50,000 2,25,000 3,75,000
Less: Pref. dividend 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
PAT for ordinary (87,500) (50,000) 25,000 1,00,000 2,50,000
shareholders
No. of Equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (0.56) (0.32) 0.16 0.64 1.60

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ii. The choice of the financing plan will depend on the state of economic conditions. If the
company’s sales are increasing, the EPS will be maximum under Plan II: Debt – Equity
Mix. Under favourable economic conditions, debt financing gives more benefit due to
tax shield availability than equity or preference financing.

iii. EBIT – EPS Indifference Point : Plan I and Plan II

EBIT * (1 - 0.40) (EBIT *- 1,25,000)   1  0.40 


3,12,500 1,56,250
3,12,500
EBIT* =  1,25,000
3,12,500 - 1,56,250
= ` 2,50,000

EBIT – EPS Indifference Point: Plan I and Plan III

EBIT*  1 - Tc  EBIT *  1  Tc   [Link].

N1 N2

3,12,500 1,25,000
= 
3,12,500 - 1,56,250 1  0.4
= ` 4,16,666.67

Question 8

There are two firms P and Q which are identical except P does not use any debt in its
capital structure while Q has ` 8,00,000, 9% debentures in its capital structure. Both the
firms have earnings before interest and tax of ` 2,60,000 p.a. and the capitalization
rate is 10%. Assuming the corporate tax of 30%, calculate the value of these firms
according to MM Hypothesis.

Answer :

Calculation of Value of Firms P and Q according to MM Hypothesis

Market Value of Firm P (Unlevered)

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Market Value of Firm Q (Levered)

VE = Vu + DT
= ` 18,20,000 + (8,00,000 × 0.30)
= ` 18,20,000 + 2,40,000 = ` 20,60,000

Question 9

The management of Z Company Ltd. wants to raise its funds from market to meet
out the financial demands of its long-term projects. The company has various
combinations of proposals to raise its funds. You are given the following proposals of the
company:
i.
Proposals % of Equity % of Debts % of Preference shares
P 100 - -
Q 50 50 -
R 50 - 50

ii. Cost of debt – 10%

Cost of preference shares – 10%
iii. Tax rate – 50%
iv. Equity shares of the face value of ` 10 each will be issued at a premium of ` 10
per share.
v. Total investment to be raised ` 40,00,000.
vi. Expected earnings before interest and tax ` 18,00,000.
From the above proposals the management wants to take advice from you for
appropriate plan after computing the following:
 Earnings per share
 Financial break-even-point
 Compute the EBIT range among the plans for indifference. Also indicate if any
of the plans dominate.

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Answer :

i. Computation of Earnings per Share (EPS)

P Q R
Plans
` ` `
Earnings before interest & tax (EBIT) 18,00,000 18,00,000 18,00,000
Less: Interest charges - 2,00,000 -
Earnings before tax (EBT) 18,00,000 16,00,000 18,00,000
Less : Tax @ 50% 9,00,000 8,00,000 9,00,000
Earnings after tax (EAT) 9,00,000 8,00,000 9,00,000
Less : Preference share dividend - - 2,00,000
Earnings available for equity shareholders 9,00,000 8,00,000 7,00,000
No. of shares 2,00,000 1,00,000 1,00,000
E.P.S (`) 4.5 8 7

ii. Computation of Financial Break-even Points

Proposal ‘P’ = 0
Proposal ‘Q’ = ` 2,00,000 (Interest charges)
Proposal R = Earnings required for payment of preference share dividend
i.e. ` 2,00,000 ÷ 0.5 (Tax Rate) = ` 4,00,000

iii. Computation of Indifference Point between the Proposals

The indifference point

 EBIT  l 1  1  T    EBIT  l 2  1  T 
E1 E2
Where,
EBIT = Earnings before interest and tax
l1 = Fixed Charges (Interest) under Proposal ‘P’
l2 = Fixed charges (Interest) under Proposal ‘Q’
T = Tax Rate
E1 = Number of Equity shares in Proposal P
E2 = Number of Equity shares in Proposal Q

Combination of Proposals

a. Indifference point where EBIT of proposal “P” and proposal ‘Q’ is equal
(EBIT - 0)(1- .5) (EBIT - 2,00,000)(1- 0.5)

2,00,000 1,00,000
.5 EBIT (1,00,000) = (.5 EBIT -1,00,000) 2,00,000

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.5 EBIT = EBIT – 2,00,000

EBIT = ` 4,00,000

b. Indifference point where EBIT of proposal ‘P’ and Proposal ‘R’ is equal:
(EBIT -1)(1- T) (EBIT - 12)(1 - T)
 - Preference share dividend
E1 E2
(EBIT - 0)(1 - .5) (EBIT - 0)(1 - .5) - 2,00,000

2,00,000 1,00,000

.25 EBIT = 0.5 EBIT -2,00,000

EBIT = 2,00,000 ÷ 0.25 = ` 8,00,000

c. Indifference point where EBIT of proposal ‘Q’ and proposal ‘R’ are equal
(EBIT - 2,00,000)(1 - 0.5) (EBIT - 0)(1 - 0.5) - 2,00,000

1, 00, 000 1, 00, 000
.5 EBIT -1,00,000 = .5 EBIT – 2,00,000
There is no indifference point between proposal ‘Q’ and proposal ‘R’

Analysis: It can be seen that Financial proposal ‘Q’ dominates proposal ‘R’, since the
financial break-even-point of the former is only ` 2,00,000 but in case of latter, it is `
4,00,000.

Question 10

X Ltd. is considering the following two alternative financing plans:

Plan - I Plan - II
` `
Equity shares of ` 10 each 4,00,000 4,00,000
12% Debentures 2,00,000 -
Preference Shares of ` 100 each - 2,00,000
6,00,000 6,00,000
The indifference point between the plans is ` 2,40,000. Corporate tax rate is 30%. Calculate
the rate of dividend on preference shares.

Answer :

Computation of Rate of Preference Dividend

EBIT = 2,40,000
Tax rate = 30%

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(EBIT - Interest) (1- Tax rate) EBIT (1- Tax rate) - Preference Dividend

No. of Equity Shares (N 1 ) No. of Equity Shares (N 2 )
(2,40,000 - 24,000) (1- 0.30) 2,40,000 (1- 0.30) - Preference Dividend

40,000 40,000
2,16,000 (1- 0.30) 1,68,000 - Preference Dividend

40,000 40,000
1,51,200 = 1,68,000 – Preference Dividend
Preference Dividend = 1,68,000 – 1,51,200
Preference Dividend = 16,800
Preference Dividend 16,800
Rate of Dividend   100   100  8.4%
Preference Share Capital 2,00,000

Question 11

'A' Ltd. and 'B' Ltd. are identical in every respect except capital structure. 'A' Ltd.
does not employ debts in its capital structure whereas 'B' Ltd. employs 12% Debentures
amounting to ` 10 lakhs. Assuming that :

i. All assumptions of M-M model are met;

ii. Income-tax rate is 30%;
iii. EBIT is ` 2,50,000 and
iv. The Equity capitalization rate of ‘A' Ltd. is 20%.

Calculate the value of both the companies and also find out the Weighted Average
Cost of Capital for both the companies.

Answer :

i. Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis

Market Value of ‘A Ltd’ (Unlevered)
EBIT  1  t 
Vu 
Ke
2,50,000  1 - 0.30 
=
20%
1,75,000
=  8,75,000
20%
Market Value of ‘B Ltd.’ (Levered)
VE = Vu + DT
= 8,75,000 + (10,00,000  0.30)
= 8,75,000 + 3,00,000 = ` 11,75,000
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ii. Computation of Weighted Average Cost of Capital (WACC)

WACC of ‘A Ltd.’ = 20% (Ke =Ko)
WACC of ‘B Ltd.’
B Ltd.
EBIT 2,50,000
Interest to Debt holders (1,20,000)
EBT 1,30,000
Taxes @ 30% (39,000)
Income available to Equity Shareholders 91,000
Total Value of Firm 11,75,000
Less: Market Value of Debt (10,00,000)
Market Value of Equity 1,75,000
Ke = 91,000 / 1,75,000 0.52

For Computation of WACC B. Ltd

Component of Costs Amount Weight Cost of WACC
Capital
Equity 1,75,000 0.149 0.52 0.0775
Debt 10,00,000 0.851 0.084* 0.0715
11,75,000 0.1490

Kd = 12% (1- 0.3) = 12% x 0.7 = 8.4%

WACC = 14.90%

Source : ICAI, PM (Old) - (From Question No. 12 - 16 )

Question 12

Calculate the level of earnings before interest and tax (EBIT) at which the EPS indifference
point between the following financing alternatives will occur.
i. Equity share capital of ` 6,00,000 and 12% debentures of ` 4,00,000.
Or
ii. Equity share capital of ` 4,00,000, 14% preference share capital of ` 2,00,000 and 12%
debentures of ` 4,00,000.
Assume the corporate tax rate is 35% and par value of equity share is ` 10 in each case.

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Answer :

Computation of level of earnings before interest and tax (EBIT)

In case alternative (i) is accepted, then the EPS of the firm would be:
(EBIT - Interest) (1 - tax rate)
EPS Alternative (i) 
No. of equity shares
(EBIT - 0.12  ` 4,00,000) (1 - 0.35)
=
60,000 shares
In case the alternative (ii) is accepted, then the EPS of the firm would be
(EBIT - 0.12  ` 4,00,000) (1 - 0.35) - (0.14  ` 2,00,000)
EPS Alternative (ii) 
40,000 shares
In order to determine the indifference level of EBIT, the EPS under the two alternative plans
should be equated as follows:
(EBIT - 0.12  ` 4,00,000) (1 - 0.35) (EBIT - 0.12  ` 4,00,000) (1 - 0.35) - (0.14  ` 2,00,000)
=
60,000 shares 40,000 shares
0.65 EBIT - ` 31,200 0.65 EBIT - ` 59,200
Or, =
3 2
Or 1.30EBIT - ` 62,400 = 1.95 EBIT - `1,77,600
Or (1.95 - 1.30) EBIT = `1,77,600 - `62,400 = `1,15,200
` 1,15,200
Or EBIT =
0.65
Or EBIT = ` 1,77,231

Question 13

A new project is under consideration in Zip Ltd., which requires a capital investment of
` 4.50 crores. Interest on term loan is 12% and Corporate Tax rate is 50%. If the Debt
Equity ratio insisted by the financing agencies is 2 : 1, calculate the point of indifference for
the project.

Answer :

The capital investment can be financed in two ways i.e.

i. By issuing equity shares only worth `4.5 crore or
ii. By raising capital through taking a term loan of ` 3 crores and ` 1.50 crores through
issuing equity shares (as the company has to comply with the 2 : 1 Debt Equity ratio
insisted by financing agencies).

In first option interest will be Zero and in second option the interest will be ` 36,00,000
Point of Indifference between the above two alternatives

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EBIT1 × (1- t) (EBIT2 - Interest) × (1- t)

= 
[Link] equity shares (N 1 ) [Link] equity shares (N 2 )
EBIT(1- 0.50) (EBIT - ` 36,00,000) × (1- 0.50)
Or = 
45,00,000 shares 15,00,000 shares
Or, 0.5 EBIT = 1.5 EBIT – ` 54,00,000
EBIT = ` 54,00,000

EBIT at point of Indifference will be ` 54 Lakhs.

(The face value of the equity shares is assumed as `10 per share. However, indifference
point will be same irrespective of face value per share).

Question 14

Z Ltd.’s operating income (before interest and tax) is ` 9,00,000. The firm’s cost of debt is 10
per cent and currently firm employs ` 30,00,000 of debt. The overall cost of capital of firm
is 12 per cent.

Required:
Calculate cost of equity.

Answer :

EBIT ` 9,00,000
Value of a firm (V) =  or,  ` 75,00,000
Overall cost of capital(K 0 ) 0.12
Market value of equity (S) = Value of the firm (V) – Value of Debts (D)
= ` 75,00,000 – `30,00,000 = ` 45,00,000
S D
Overall Cost of Capital (K0) = K e    K d  
V V

Question 15

RES Ltd. is an all equity financed company with a market value of ` 25,00,000 and cost of
equity (Ke) 21%. The company wants to buyback equity shares worth ` 5,00,000 by issuing
and raising 15% perpetual debt of the same amount. Rate of tax may be taken as 30%.

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After the capital restructuring and applying MM Model (with taxes), you are required to
calculate:
i. Market value of RES Ltd.
ii. Cost of Equity (Ke)
iii. Weighted average cost of capital (using market weights) and comment on it.

Answer :

Value of a company (V) = Value of equity (S) + Value of debt (D)

Net Income (NI)
` 25,00,000 = ` 5, 00, 000
Ke
Or, Net Income (NI) = 0.21 (`25,00,000 – `5,00,000)
Market Value of Equity = 25,00,000
Ke = 21%
Net income (NI) for equity- holders
 Market Value of Equity
Ke
Net income (NI) for equity holders
= 25,00,000
0.21
Net income for equity holders = 5,25,000
EBIT= 5,25,000/0.7 = 7,50,000

All Debt and

Equity Equity
EBIT 7,50,000 7,50,000
Interest to Debt - holders - 75,000
EBT 7,50,000 6,75,000
Taxes @ 30% 2,25,000 2,02,500
Income available to Equity Shareholders 5,25,000 4,72,500
Income to debt holders plus income available to shareholders 5,25,000 5,47,500

Present value of tax-shield benefits = ` 5,00,000 × 0.30 = `1,50,000

i. Value of Restructured firm
= ` 25,00,000 + ` 1,50,000 = ` 26,50,000

ii. Cost of Equity (Ke)

Total Value = ` 26,50,000
Less: Value of Debt = ` 5,00,000
Value of Equity = ` 21,50,000
4,72,500
Ke   0.219  21.98%
21,50,000

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iii. WACC (on market value weight)

Cost of Debt (after tax) = 15% (1- 0.3) = 0.15 (0.70) = 0.105 = 10.5%
Components of Costs Amount Cost of Capital(%) Weight WACC(%)
Equity 21,50,000 21.98 0.81 17.80
Debt 5,00,000 10.50 0.19 2.00
26,50,000 19.80

Comment: At present the company is all equity financed. So, Ke = Ko i.e. 21%. However
after restructuring, the Ko would be reduced to 19.80% and Ke would increase from 21%
to 21.98%.

Question 16

A Company earns a profit of ` 3,00,000 per annum after meeting its Interest liability
of ` 1,20,000 on 12% debentures. The Tax rate is 50%. The number of Equity Shares of ` 10
each are 80,000 and the retained earnings amount to ` 12,00,000. The company proposes to
take up an expansion scheme for which a sum of ` 4,00,000 is required. It is anticipated that
after expansion, the company will be able to achieve the same return on investment as at
present. The funds required for expansion can be raised either through debt at the rate of
12% or by issuing Equity Shares at par.

Required:
i. Compute the Earnings per Share (EPS), if:
 The additional funds were raised as debt
 The additional funds were raised by issue of equity shares.
ii. Advise the company as to which source of finance is preferable.

Answer :

Working Notes:

1. Capital employed before expansion plan:

(`)
Equity shares (`10 × 80,000 shares) 8,00,000
Debentures {(` 1,20,000/12)  100} 10,00,000
Retained earnings 12,00,000
Total capital employed 30,00,000

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2. Earnings before the payment of interest and tax (EBIT):

(`)
Profit (EBT) 3,00,000
Interest 1,20,000
EBIT 4,20,000

3. Return on Capital Employed (ROCE):

4. Earnings before interest and tax (EBIT) after expansion scheme:

After expansion, capital employed = ` 30,00,000 + `4,00,000 = ` 34,00,000
Desired EBIT = 14%  `34,00,000 = `4,76,000

i. Computation of Earnings Per Share (EPS) under the following options:

Present Expansion scheme
situation Additional funds raised as
Debt Equity
(`) (`) (`)
Earnings before Interest and Tax (EBIT) 4,20,000 4,76,000 476,000
Less: Interest
- Old capital 1,20,000 1,20,000 1,20,000
- New capital -- 48,000 --
(`4,00,000  12%)
Earnings before Tax (EBT) 3,00,000 3,08,000 3,56,000
Less: Tax (50% of EBT) 1,50,000 1,54,000 1,78,000
PAT 1,50,000 1,54,000 1,78,000
No. of shares outstanding 80,000 80,000 1,20,000
Earnings per Share (EPS) 1.875 1.925 1.48

ii. Advise to the Company: When the expansion scheme is financed by additional debt,
the EPS is higher. Hence, the company should finance the expansion scheme by raising
debt.

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 FINANCING DECISIONS- CAPITAL STRUCTURE

 OTHER PROBLEMS

Question 1

M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000
outstanding shares and the current market price is Rs. 100. It expects a net profit of Rs.
2,50,000 for the year and the Board is considering dividend of Rs. 5 per share.

M Ltd. requires to raise Rs. 5,00,000 for an approved investment expenditure. Analyse,
how the MM approach affects the value of M Ltd. if dividends are paid or not paid.
Source : ICAI, MTP I (New)
Answer :

A. When dividend is paid

a. Price per share at the end of year 1
1
100   ` 5  P1 
1.10
110 = Rs. 5 + P1
P1 = 105
b. Amount required to be raised from issue of new shares
Rs.5,00,000 – (Rs.2,50,000 – Rs.1,25,000)
Rs.5,00,000 – Rs.1,25,000 = Rs.3,75,000
c. Number of additional shares to be issued
3,75,000 75,000
 shares or say 3,572 shares
105 21
d. Value of M Ltd.
(Number of shares × Expected Price per share)
i.e., (25,000 + 3,572) × Rs.105 = Rs.30,00,060

B. When dividend is not paid

a. Price per share at the end of year 1
P
100  1
1.10
P1 = 110
b. Amount required to be raised from issue of new shares
Rs.5,00,000 – 2,50,000 = 2,50,000

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c. Number of additional shares to be issued

2,50,000 25,000
 shares or say 2,273 shares.
110 11
d. Value of M Ltd.,
(25,000 + 2273) × Rs.110
= Rs.30,00,030
Whether dividend is paid or not, the value remains the same.

Question 2

Stopgo Ltd, an all equity financed company, is considering the repurchase of ` 200 lakhs
equity and to replace it with 15% debentures of the same amount. Current market Value of
the company is ` 1140 lakhs and it's cost of capital is 20%. It's Earnings before
Interest and Taxes (EBIT) are expected to remain constant in future. It's entire earnings are
distributed as dividend. Applicable tax rate is 30 per cent.
You are required to calculate the impact on the following on account of the change in the
capital structure as per Modigliani and Miller (MM) Hypothesis:
i. The market value of the company
ii. It's cost of capital, and
iii. It’s cost of equity
Source : ICAI, May 2018 Question Paper
Answer :

Working Note :
Net income (NI) for equity - holders
= Market Value of Equity
Ke
Net income (NI) for equity holders
= ` 1,140 lakhs
0.20
Therefore, Net Income to equity–holders = ` 228 lakhs
EBIT = ` 228 lakhs / 0.7 = ` 325.70 lakhs
All Equity Debt of Equity
(` In lakhs) (` In lakhs)
EBIT 325.70 325.70
Interest on `200 lakhs @ 15% -- 30.00
EBT 325.70 295.70
Tax @ 30 % 97.70 88.70
Income available to equity holders 228 207

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i. Market value of levered firm = Value of unlevered firm + Tax Advantage

= ` 1,140 lakhs + (`200 lakhs x 0.3)
= ` 1,200 lakhs
The impact is that the market value of the company has increased by ` 60 lakhs (`1,200
lakhs – ` 1,140 lakhs)
Calculation of Cost of Equity
Ke = (Net Income to equity holders / Equity Value ) X 100
= (207 lakhs / 1200 lakhs – 200 lakhs ) X 100
= (207/ 1000) X 100
= 20.7 %

ii. Cost of Capital

Amount Cost of Capital % Weight WACC %
Components
(` In lakhs)
Equity 1000 20.7 83.33 17.25
Debt 200 (15% X 0.7) =10.5 16.67 1.75
1200 19.00

The impact is that the WACC has fallen by 1% (20% - 19%) due to the benefit of tax relief
on debt interest payment.

iii. Cost of Equity is 20.7% [As calculated in point (i)]

The impact is that cost of equity has risen by 0.7% i.e. 20.7% - 20% due to the
presence of financial risk.
Further, Cost of Capital and Cost of equity can also be calculated with the help of
formulas as below, though there will be no change in final answers.
Cost of Capital (Ko) = Keu(1-tL)
Where,
Keu = Cost of equity in an unlevered company
t = Tax rate
Debt
L
Debt  Equity

So, Cost of capital = 0.19 or 19%

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Where,
Keu = Cost of equity in an unlevered company
Kd = Cost of debt
t = Tax rate

Ke = 0.20 + 0.007 = 0.207 or 20.7%

So, Cost of Equity = 20.70%

Question 3

Sun Ltd. is considering two financing plans.

Details of which are as under:
i. Fund's requirement – ` 100 Lakhs
ii. Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%

iii. Cost of debt – 12% p.a.

iv. Tax Rate – 30%
v. Equity Share ` 10 each, issued at a premium of ` 15 per share
vi. Expected Earnings before Interest and Taxes (EBIT) ` 40 Lakhs

You are required to compute:

i. EPS in each of the plan
ii. The Financial Break Even Point
iii. Indifference point between Plan I and II
Source : ICAI, May 2018 Question Paper
Answer :

i. Computation of Earnings Per Share (EPS)

Plans I (`) II (`)
Earnings before interest & tax (EBIT) 40,00,000 40,00,000
Less: Interest charges (12% of `75 lakh) -- (9,00,000)
Earnings before tax (EBT) 40,00,000 31,00,000
Less: Tax @ 30% (12,00,000) (9,30,000)
Earnings after tax (EAT) 28,00,000 21,70,000
No. of equity shares (@ `10+`15) 4,00,000 1,00,000
E.P.S (`) 7.00 21.70

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ii. Computation of Financial Break-even Points

Plan ‘I’ = 0 – Under this plan there is no interest payment, hence the financial break -
even point will be zero.
Plan ‘II’ = ` 9,00,000 - Under this plan there is an interest payment of `9,00,000,
hence the financial break -even point will be `9 lakhs

iii. Computation of Indifference Point between Plan I and Plan II:

Indifference point is a point where EBIT of Plan-I and Plan-II are equal. This can be
calculated by applying the following formula:
{(EBIT –I1 ) (1- T)} / E1 = {(EBIT –I2 ) (1- T)} / E2
EBIT(1- 0.3) (EBIT - ` 9,00,000)(1- 0.3)

4,00,000shares 1,00,000shares
Or, 2.8 EBIT – 25,20,000 = 0.7EBIT
Or, 2.1EBIT = 25,20,000
EBIT =12,00,000

Question 4

Company P and Q are identical in all respects including risk factors except for debt/equity,
company P having issued 10% debentures of ` 18 lakhs while company Q is unlevered.
Both the companies earn 20% before interest and taxes on their total assets of ` 30 lakhs.
Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity company.

Required:
Calculate the value of companies’ P and Q using
i. Net Income Approach and
ii. Net Operating Income Approach.
Source : ICAI, RTP May 2018(New)
Answer :

i. Valuation under Net Income Approach

Particulars P Q
Amount (`) Amount (`)
Earnings before Interest & Tax (EBIT) 6,00,000 6,00,000
(20% of ` 30,00,000)
Less: Interest (10% of ` 18,00,000) 1,80,000
Earnings before Tax (EBT) 4,20,000 6,00,000
Less: Tax @ 50% 2,10,000 3,00,000
Earnings after Tax (EAT)
2,10,000 3,00,000
(available to equity holders)

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Value of equity (capitalized @ 15%) 14,00,000 20,00,000

(2,10,000 × 100/15) (3,00,000 × 100/15)
Add: Total Value of debt 18,00,000 Nil
Total Value of Company 32,00,000 20,00,000

ii. Valuation of Companies under Net Operating Income Approach

Particulars P Q
Amount (`) Amount (`)
Capitalisation of earnings at 15%
20,00,000 20,00,000

Less: Value of debt 9,00,000 Nil

{18,00,000 (1 – 0.5)}
Value of equity 11,00,000 20,00,000
Add: Total Value of debt 18,00,000 Nil
Total Value of Company 29,00,000 20,00,000

Question 5

The Modern Chemicals Ltd. requires Rs. 25,00,000 for a new plant. This plant is expected to
yield earnings before interest and taxes of Rs. 5,00,000. While deciding about the
financial plan, the company considers the objective of maximising earnings per share.
It has three alternatives to finance the project- by raising debt of Rs. 2,50,000 or Rs.
10,00,000 or Rs. 15,00,000 and the balance, in each case, by issuing equity shares. The
company’s share is currently selling at Rs. 150, but is expected to decline to Rs.
125 in case the funds are borrowed in excess of Rs. 10,00,000. The funds can be
borrowed at the rate of 10% upto Rs. 2,50,000, at 15% over Rs. 2,50,000 and upto Rs.
10,00,000 and at 20% over Rs. 10,00,000. The tax rate applicable to the company is 50%.
Which form of financing should the company choose?
Source : ICAI, MTP II (Old)

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Answer :

Calculation of Earnings per share for three alternatives to finance the project
Alternatives
I II III
To raise debt of To raise debt of Rs. To raise debt of Rs.
Particulars
Rs.2,50,000 and 10,00,000 and equity 15,00,000 and equity
equity of ` 22,50,000 of ` 15,00,000 of ` 10,00,000
` ` `
Earnings before 5,00,000 5,00,000 5,00,000
interest and tax
Less: Interest on debt 25,000 1,37,500 2,37,500
at the rate of (10% on Rs. 2,50,000) (10% on Rs. 2,50,000) (10% on Rs. 2,50,000)
(15% on Rs. 7,50,000) (15% on Rs. 7,50,000)
(20% on Rs. 5,00,000)
Earnings before tax 4,75,000 3,62,500 2,62,500
Less: Tax (@ 50%) 2,37,500 1,81,250 1,31,250
Earnings after tax:
2,37,500 1,81,250 1,31,250
(A)
Number of shares :
(B) 15,000 10,000 8,000
(Refer to working note)
Earnings per share :
15.833 18.125 16.406
(A)/(B)

So, the earning per share (EPS) is higher in alternative II i.e. if the company finance the
project by raising debt of Rs. 10,00,000 and issue equity shares of Rs. 15,00,000. Therefore
the company should choose this alternative to finance the project.

Working Note:
Alternatives
I II III
Equity financing : (A) Rs. 22,50,000 Rs. 15,00,000 Rs. 10,00,000
Market price per share : (B) Rs. 150 Rs. 150 Rs. 125
Number of equity share : (A)/(B) 15,000 10,000 8,000

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Question 6

The following current data are available concerning Theta Limited:

Share issued `10,000
Market price per share `20
Interest rate 12%
Tax Rate 46%
Expected EBIT `15,000

The company requires an additional `50,000 for the coming year.

You are required to determine:

i. Which financing option (debt or equity issue) will give higher EPS for the expected
EBIT?
ii. What is indifference level of EBIT for the two alternatives?
iii. What is EPS for that EBIT?
Source : ICAI, RTP November 2013(Old)
Answer :

i. Computation of Earnings Per Share (EPS) for the Expected Earnings Before
Interest and Taxes(EBIT) for the Expected EBIT.
Debt (`) Equity (`)
Expected earnings before interest & tax 15,000 15,000
Less: Interest (12% of ` 50,000) 6,000 -
Earnings before tax (EBT) 9,000 15,000
Less: Tax (@ 46%) of EBT (`9000  46%) 4,140 6,900
Earnings available to equity shareholder: (A) 4,860 8,100
Number of shares issued: (B) 10,000 12,500
(Refer to working note)
Earnings per shares: (A) / (B) 0.486 0.648

Conclusion: Earnings per share is higher when the company raises additional funds by
issue of equity shares.

Working note
Number of new shares to be issued:
Amount required: (i) ` 50,000
Market price per share (ii) ` 20
No. of new shares to be issued: (i) / (ii) 2,500

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ii. Computation of indifference level of EBIT for the two alternatives

or, EBIT = ` 30,000

Therefore, Indifference level of EBIT for two alternatives is `30,000.

iii. The EPS for the EBIT at the indifference level.

= `1.296 per share

Question 7

The earnings of Alpha Limited were ` 3 per share in year 1. They increased over a 10 year
period to ` 4.02. You are required to compute the rate of growth or compound
annual rate of growth of the earnings per share.
Source : ICAI, RTP May 2014(Old)
Answer :

Compound Annual Rate of Growth in Earnings per Share

Fn = P × FVIFi, n
F
FVIFi ,n  n
P
` 4.02
FVIFi ,10   1.340
`3
An FVIF of 1.340 at 10 years is at 3 percent interest. The compound annual rate of growth
in earnings per share is, therefore, 3 percent.

Question 8

The following figures of Theta Limited are presented as under:

` `
Earnings before Interest and Tax 23,00,000
Less: Debenture Interest @ 8% 80,000
Long Term Loan Interest @ 11% 2,20,000 3,00,000
20,00,000
Less: Income Tax 10,00,000
Earnings after tax 10,00,000

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No. of Equity Shares of ` 10 each 5,00,000

EPS `2
Market Price of Share ` 20
P/E Ratio 10

The company has undistributed reserves and surplus of ` 20 lakhs. It is in need of ` 30

lakhs to pay off debentures and modernise its plants. It seeks your advice on the following
alternative modes of raising finance.
Alternative 1 - Raising entire amount as term loan from banks @ 12%.
Alternative 2 - Raising part of the funds by issue of 1,00,000 shares of ` 20 each and
the rest by term loan at 12 percent.
The company expects to improve its rate of return by 2 percent as a result of
modernisation, but P/E ratio is likely to go down to 8 if the entire amount is raised as term
loan.
i. Advise the company on the financial plan to be selected.
ii. If it is assumed that there will be no change in the P/E ratio if either of the
two alternatives is adopted, would your advice still hold good?
Source : ICAI, RTP May 2014(Old)
Answer :

Working Notes:

i. Capital Employed
`
Equity Capital (5,00,000 shares of ` 10 each) 50,00,000
Debentures (` 80,000×100/8) 10,00,000
Term Loan (` 2,20,000×100/11) 20,00,000
Reserves and Surplus 20,00,000
Total Capital Employed 1,00,00,000

ii. Rate of Return

Earnings before Interest and Tax = ` 23,00,000
23,00,000
Rate of Return on Capital Employed =  100  23%
1,00,00,000

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iii. Expected Rate of Return after Modernisation = 23% + 2% = 25%

Alternative 1: Raise Entire Amount as Term Loan
Original Capital Employed 1,00,00,000
Less: Debentures 10,00,000
90,00,000
Add: Additional Term Loan 30,00,000
Revised Capital Employed 1,20,00,000

`
EBIT on Revised Capital Employed (@ 25% on ` 120 lakhs) 30,00,000
Less: Interest
Existing Term Loan (@11%) 2,20,000
New Term Loan (@12%) 3,60,000 5,80,000
24,20,000
Less: Income Tax (@ 50%) 12,10,000
Earnings after Tax (EAT) 12,10,000

Market Price per Share

P/E Ratio  8
EPS
Market Price
8
` 2.42
Market Price = ` 19.36

Alternative 2: Raising Part by Issue of Equity Shares and Rest by Term Loan
`
Earnings before Interest and Tax (@ 25% on Revised
30,00,000
Capital Employed i.e., ` 120 lakhs)
Less: Interest
Existing Term Loan @ 11% 2,20,000
New Term Loan @ 12% 1,20,000 3,40,000
26,60,000
Less: Income Tax @ 50% 13,30,000
Earnings after Tax 13,30,000

P/E Ratio = 10
Market Price = ` 22.17
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Advise:
i. From the above computations it is observed that the market price of Equity
Shares is maximised under Alternative 2. Hence this alternative should be
selected.
ii. If, under the two alternatives, the P/E ratio remains constant at 10, the market price
under Alternative 1 would be ` 24.20. Then Alternative 1 would be better than
Alternative 2.

Question 9

Theta Limited has a total capitalization of ` 10 Lakhs consisting entirely of equity shares of
` 50 each. It wishes to raise another ` 5 lakhs for expansion through one of its two possible
financial plans.
1. All equity shares of ` 50 each.
2. All debentures carrying 9% interest.
The present level of EBIT is ` 1,40,000 and Income tax rate is 50%.
Calculate EBIT level at which earnings per share would remain the same irrespective of
raising funds through equity shares or debentures.
Source : ICAI, RTP November 2014(Old)
Answer :

Computation of Level of EBIT where EPS will be Equal for Both Alternatives
The level of EBIT where EPS will be equal under both the alternatives can be
ascertained by the following equation:

In Alternative 1, there will be no fixed interest liability, Equity shares=

20,000+10,000=30,000.

In Alternative 2, debentures of ` 5 lakhs carrying 9% interest will be used.

Debentures interest will be:
9 × 5,00,000
` 45,000
100
Substituting the values in the above equation:

or
X = 1,35,000

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At EBIT level of ` 1,35,000 earnings per share in both cases will be equal:
Calculation of EPS
Alternative 1 Alternative 2
Equity Shares (A) 30,000 20,000
Debentures 0 5,00,000
EBIT `1,35,000 `1,35,000
Interest 0 45,000
`1,35,000 90,000
Less: Income Tax @ 50% 67,500 45,000
Earnings after Tax (B) 67,500 45,000

B
EPS   2.25
A

Question 10

Akash Limited provides you the following information:

(`)
Profit (EBIT) 2,80,000
Less: Interest on Debenture @ 10% 40,000
EBT 2,40,000
Less Income Tax @ 50% 1,20,000
1,20,000
No. of Equity Shares ( ` 10 each) 30,000
Earnings per share (EPS) 4
Price /EPS (PE) Ratio 10

The company has reserves and surplus of ` 7,00,000 and required ` 4,00,000 further for
modernisation. Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt +
Equity) Ratio higher than 40% will bring the P/E Ratio down to 8 and increase the interest
rate on additional debts to 12%. You are required to ascertain the probable price of the
share.
i. If the additional capital are raised as debt; and
ii. If the amount is raised by issuing equity shares at ruling market price.

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Answer :

Ascertainment of probable price of shares of Akash limited

Plan-I Plan-II
If ` 4,00,000 is
If ` 4,00,000 is
Particulars raised by issuing
raised as debt
equity shares
(`)
(`)
Earnings Before Interest and Tax (EBIT)
{20% of new capital i.e. 20% of (`14,00,000 +
3,60,000 3,60,000
`4,00,000)}
(Refer working note1)
Less: Interest on old debentures (40,000) (40,000)
(10% of `4,00,000)
Less: Interest on new debt
(48,000) --
(12% of `4,00,000)
Earnings Before Tax (EBT) 2,72,000 3,20,000
Less: Tax @ 50% (1,36,000) 1,60,000
Earnings for equity shareholders (EAT) 1,36,000 1,60,000
No. of Equity Shares
30,000 40,000
(refer working note 2)
Earnings per Share (EPS) 4.53 4.00
Price/ Earnings (P/E) Ratio
8 10
(refer working note 3)
Probable Price Per Share (PE Ratio × EPS) ` 36.24 ` 40

Working Notes:
1. Calculation of existing Return of Capital Employed (ROCE):
(`)
Equity Share capital (30,000 shares × `10) 3,00,000
4,00,000
10% Debentures

Reserves and Surplus 7,00,000

Total Capital Employed 14,00,000
Earnings before interest and tax (EBIT) (given) 2,80,000

20%

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2. Number of Equity Shares to be issued in Plan-II:

Thus, after the issue total number of shares = 30,000+ 10,000 = 40,000 shares

3. Debt/Equity Ratio if ` 4,00,000 is raised as debt:

As the debt equity ratio is more than 40% the P/E ratio will be brought down to 8 in
Plan-I

Question 11

The following is an extract from the financial statements of Zeta Limited:

Amount (`lakhs)
Operating Profit 105.0
Less: Interest on Debentures 33.0
Earnings before Taxes 72.0
Less: Income Tax (35%) 25.2
Earnings after Taxes 46.8
Equity Share Capital (shares of ` 10 each) 200.0
Reserves and Surplus 100.0
15% Non-Convertible Debentures (of ` 100 each) 220.0q
520.0

The market price per equity share is ` 12 and per debenture is ` 93.75.

You are required to calculate:

a. The earnings per share.
b. The percentage cost of capital to the company for debentures and the equity.
Source : ICAI, RTP May 2014(Old)
Answer :

a. EPS = EAT/Number of shares = ` 46.8 lakhs / 20 lakhs = ` 2.34

b.
i. Cost of Debentures (book value) = ` 33 lakhs (1 – 0.35) / ` 220 lakhs = 9.75 per cent
ii. Cost of Debentures (market value) = ` 15 (1 – 0.35) / ` 93.75 = 10.4 per cent
iii. Cost of Equity (earnings-approach) = EPS/MPS = ` 2.34/` 12 = 19.5 per cent.

Note: Cost of debentures based on market value is more appropriate).

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 THEORETICAL QUESTIONS

Source : ICAI, Compilation (Old) - (From Question No. 1 - 13 )

Question 1

Discuss the relationship between the financial leverage and firms required rate of
return to equity shareholders as per Modigliani and Miller Proposition II.

Answer :

Relationship between the financial leverage and firm’s required rate of return to
equity shareholders with corporate taxes is given by the following relation:

Where,
rE = required rate of return to equity shareholders
r0 = required rate of return for an all equity firm
D = Debt amount in capital structure
E = Equity amount in capital structure
TC = Corporate tax rate
rB = required rate of return to lenders

Question 2

Discuss the major considerations in capital structure planning.

Answer :

Major considerations in capital structure planning

There are three major considerations, i.e. risk, cost of capital and control, which help
the finance manager in determining the proportion in which he can raise funds from
various sources.

Although, three factors, i.e., risk, cost and control determine the capital structure of
a particular business undertaking at a given point of time.

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Risk: The finance manager attempts to design the capital structure in such a manner, so
that risk and cost are the least and the control of the existing management is diluted to the
least extent. However, there are also subsidiary factors also like - marketability of the
issue, manoeuvrability and flexibility of the capital structure, timing of raising the funds.
Risk is of two kinds, i.e., Financial risk and Business risk. Here we are concerned primarily
with the financial risk. Financial risk also is of two types:
 Risk of cash insolvency
 Risk of variation in the expected earnings available to equity share-holders

Cost of Capital: Cost is an important consideration in capital structure decisions. It is

obvious that a business should be at least capable of earning enough revenue to meet its
cost of capital and finance its growth. Hence, along with a risk as a factor, the finance
manager has to consider the cost aspect carefully while determining the capital structure.

Control: Along with cost and risk factors, the control aspect is also an important
consideration in planning the capital structure. When a company issues further equity
shares, it automatically dilutes the controlling interest of the present owners.
Similarly, preference shareholders can have voting rights and thereby affect the
composition of the Board of Directors, in case dividends on such shares are not paid for
two consecutive years. Financial institutions normally stipulate that they shall have one or
more directors on the Boards. Hence, when the management agrees to raise loans from
financial institutions, by implication it agrees to forego a part of its control over the
company. It is obvious, therefore, that decisions concerning capital structure are taken
after keeping the control factor in mind.

Question 3

Explain in brief the assumptions of Modigliani-Miller theory.

Answer :

Assumptions of Modigliani – Miller Theory

a. Capital markets are perfect. All information is freely available and there is no
transaction cost.
b. All investors are rational.
c. No existence of corporate taxes.
d. Firms can be grouped into “Equivalent risk classes” on the basis of their business risk.

Question 4

What is optimum capital structure? Explain.

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Answer :

Optimum Capital Structure: Optimum capital structure deals with the issue of right mix
of debt and equity in the long-term capital structure of a firm. According to this, if
a company takes on debt, the value of the firm increases upto a certain point. Beyond that
value of the firm will start to decrease. If the company is unable to pay the debt within the
specified period then it will affect the goodwill of the company in the market. Therefore,
company should select its appropriate capital structure with due consideration of all
factors.

Question 5

Explain the assumptions of Net Operating Income approach (NOI) theory of capital
structure.

Answer :

Assumptions of Net Operating Income (NOI) Theory of Capital Structure

According to NOI approach, there is no relationship between the cost of capital and value
of the firm i.e. the value of the firm is independent of the capital structure of the firm.

Assumptions
a. The corporate income taxes do not exist.
b. e market capitalizes the value of the firm as whole. Thus the split between debt and
equity is not important.
c. The increase in proportion of debt in capital structure leads to change in risk perception
of the shareholders.
d. The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

Question 6

Explain the principles of “Trading on equity”.

Answer :

The term trading on equity means debts are contracted and loans are raised mainly
on the basis of equity capital. Those who provide debt have a limited share in the firm’s
earning and hence want to be protected in terms of earnings and values represented
by equity capital. Since fixed charges do not vary with firms earnings before interest and
tax, a magnified effect is produced on earning per share. Whether the leverage is
favourable, in the sense, increase in earnings per share more proportionately to the

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increased earnings before interest and tax, depends on the profitability of investment
proposal. If the rate of returns on investment exceeds their explicit cost, financial leverage is
said to be positive.

Question 7

Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while

determining the capital structure of a company.

Answer :

Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the

Capital Structure of a Company

The determination of optimum level of debt in the capital structure of a company is

a formidable task and is a major policy decision. It ensures that the firm is able to
service its debt as well as contain its interest cost. Determination of optimum level
of debt involves equalizing between return and risk.

EBIT – EPS analysis is a widely used tool to determine level of debt in a firm.
Through this analysis, a comparison can be drawn for various methods of financing
by obtaining indifference point. It is a point to the EBIT level at which EPS remains
unchanged irrespective of debt-equity mix. The indifference point for the capital mix
(equity share capital and debt) can be determined as follows:

Question 8

What do you understand by Capital structure? How does it differ from Financial
structure?

Answer :

Meaning of Capital Structure and its Differentiation from Financial Structure

Capital Structure refers to the combination of debt and equity which a company
uses to finance its long-term operations. It is the permanent financing of the
company representing long-term sources of capital i.e. owner’s equity and long-term
debts but excludes current liabilities. On the other hand, Financial Structure is the

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entire left-hand side of the balance sheet which represents all the long-term and
short-term sources of capital. Thus, capital structure is only a part of financial structure.

Question 9

Discuss financial break-even and EBIT-EPS indifference analysis.

Answer :

Financial Break-even and EBIT-EPS Indifference Analysis

Financial break-even point is the minimum level of EBIT needed to satisfy all the
fixed financial charges i.e. interest and preference dividend. It denotes the level of EBIT for
which firm’s EPS equals zero. If the EBIT is less than the financial breakeven point,
then the EPS will be negative but if the expected level of EBIT is more than the breakeven
point, then more fixed costs financing instruments can be taken in the capital structure,
otherwise, equity would be preferred.

EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a
firm. The objective of this analysis is to find the EBIT level that will equate EPS
regardless of the financing plan chosen.

Where,
EBIT = Indifference point
E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
T = Tax-rate
Alternative 1= All equity finance
Alternative 2= Debt-equity finance.

Question 10

What is Net Operating Income (NOI) theory of capital structure? Explain the
assumptions of Net Operating Income approach theory of capital structure.

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Answer :

Net Operating Income (NOI) Theory of Capital Structure

According to NOI approach, there is no relationship between the cost of capital and value
of the firm i.e. the value of the firm is independent of the capital structure of the firm.

Assumptions
a. The corporate income taxes do not exist.
b. The market capitalizes the value of the firm as whole. Thus the split between debt and
equity is not important.
c. The increase in proportion of debt in capital structure leads to change in risk perception
of the shareholders.
d. The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

Question 11

List the fundamental principles governing capital structure.

Answer :

Fundamental Principles Governing Capital Structure

The fundamental principles are:
i. Cost Principle: According to this principle, an ideal pattern or capital structure is one
that minimises cost of capital structure and maximises earnings per share (EPS).
ii. Risk Principle: According to this principle, reliance is placed more on common equity
for financing capital requirements than excessive use of debt. Use of more and
more debt means higher commitment in form of interest payout. This would lead
to erosion of shareholders value in unfavourable business situation.
iii. Control Principle: While designing a capital structure, the finance manager may also
keep in mind that existing management control and ownership remains undisturbed.
iv. Flexibility Principle: It means that the management chooses such a combination
of sources of financing which it finds easier to adjust according to changes in need of
funds in future too.
v. Other Considerations: Besides above principles, other factors such as nature of
industry, timing of issue and competition in the industry should also be considered.

Question 12

What do you mean by capital structure? State its significance in financing decision.

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Answer :

Concept of Capital Structure and its Significance in Financing Decision

Capital structure refers to the mix of a firm’s capitalisation i.e. mix of long-term
sources of funds such as debentures, preference share capital, equity share capital
and retained earnings for meeting its total capital requirement.

Significance in Financing Decision

The capital structure decisions are very important in financial management as they
influence debt – equity mix which ultimately affects shareholders return and risk. These
decisions help in deciding the forms of financing (which sources to be tapped), their
actual requirements (amount to be funded) and their relative proportions (mix) in
total capitalisation. Therefore, such a pattern of capital structure must be chosen
which minimises cost of capital and maximises the owners’ return.

Question 13

What is Over-capitalisation? State its causes and consequences.

Answer :

Overcapitalization and its Causes and Consequences

It is a situation where a firm has more capital than it needs or in other words assets are
worth less than its issued share capital, and earnings are insufficient to pay dividend and
interest.

Causes of Over Capitalization

Over-capitalisation arises due to following reasons:
i. Raising more money through issue of shares or debentures than company can
employ profitably.
ii. Borrowing huge amount at higher rate than rate at which company can earn.
iii. Excessive payment for the acquisition of fictitious assets such as goodwill etc.
iv. Improper provision for depreciation, replacement of assets and distribution of
dividends at a higher rate.
v. Wrong estimation of earnings and capitalization.

Consequences of Over-Capitalisation
Over-capitalisation results in the following consequences:
i. Considerable reduction in the rate of dividend and interest payments.
ii. Reduction in the market price of shares.

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iii. Resorting to “window dressing”.

iv. Some companies may opt for reorganization. However, sometimes the matter gets
worse and the company may go into liquidation.

Question 14

Explain the risks associated with capital structure.

Source : ICAI, MTP I (Old)
Answer :

There are two risks associated with this principle:

i. Business risk: It is an unavoidable risk because of the environment in which the firm
has to operate and it is represented by the variability of earnings before interest and tax
(EBIT). The variability in turn is influenced by revenues and expenses. Revenues
and expenses are affected by demand of firm products, variations in prices and
proportion of fixed cost in total cost.

ii. Financial risk: It is a risk associated with the availability of earnings per share caused
by use of financial leverage. It is the additional risk borne by the shareholders when a
firm uses debt in addition to equity financing.

Generally, a firm should neither be exposed to high degree of business risk and low
degree of financial risk or vice-versa, so that shareholders do not bear a higher risk.

Question 15

“An EBIT-EPS indifference analysis chart is used for determining the impact of a
change in sales on EBIT.” Comment.
Source : ICAI, RTP May 2014 (Old)
Answer :

The statement is incorrect as an EBIT-EPS indifference analysis chart is used for

examining EPS results for alternative financing plans at varying EBIT levels.

Question 16

If a company finds that its cost of capital has changed does this affect the
profitability of the company?
Source : ICAI, RTP May 2015 (Old)

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Answer :

The answer depends on how the company has been financed.

If the company is financed mainly from short-term sources, it cannot ignore an
increase in interest rates and may choose to switch to long-term financing. This will be at a
higher rate and profitability will be diminished.

If the company is financed mainly from long-term sources, an increase in interest

rates will not affect its profits directly. However, higher interest rates may depress
economic activity and its profits may fall accordingly.

If the company is financed mainly from retained earnings or equity, an increase in the
required return of shareholders will lead to pressure for higher dividends. The company
may have insufficient funds to meet such demands.

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Chapter
FINANCING DECISIONS
6 - LEVERAGES

LEARNING OUTCOMES
 Understand the concept of business risk and financial risk.
 Discuss and Interpret the types of leverages.
 Discuss the relationship between operating leverage and Break -even analysis.
 Discuss positive and negative Leverage.
 Discuss Financial leverage as ‘Trading on equity
 Discuss Financial leverage as ‘Double edged sword’.

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CHAPTER OVERVIEW

ANALYSIS OF LEVERAGE

Business and Financial Risk Types of Leverage

i. Operating Leverage
ii. Financial Leverage
iii. Combined Leverages

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SUMMARY

 Operating leverage exists when a firm has a fixed cost that must be defrayed
regardless of volume of business. It can be defined as the firm’s ability to use fixed
operating costs to magnify the effects of changes in sales on its earnings before
interest and taxes.
 Financial leverage involves the use fixed cost of financing and refers to mix of debt
and equity in the capitalisation of a firm. Financial leverage is a superstructure built
on the operating leverage. It results from the presence of fixed financial
charges in the firm’s income stream.
 Combined Leverage: - Combined leverage maybe defined as the potential use of
fixed costs, both operating and financial, which magnifies the effect of sales
volume change on the earning per share of the firm. Degree of combined leverage
(DCL) is the ratio of percentage change in earning per share to the percentage
change in sales. It indicates the effect the sales changes will have on EPS.

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. Given
Operating fixed costs ` 20,000
Sales ` 1,00,000
P/V ratio 40%
The operating leverage is:
a. 2.00
b. 2.50
c. 2.67
d. 2.47

2. If EBIT is ` 15,00,000, interest is ` 2,50,000, corporate tax is 40%, degree of financial

leverage is
a. 1:11
b. 1.20
c. 1.31
d. 1.41

3. If DOL is 1.24 and DFL is 1.99, DCL would be:

a. 2.14
b. 2.18
c. 2.31
d. 2.47

4. Operating Leverage is calculated as:

a. Contribution ÷ EBIT
b. EBIT ÷ PBT
c. EBIT ÷ Interest
d. EBIT ÷ Tax

5. Financial Leverage is calculated as:

a. EBIT ÷ Contribution
b. EBIT ÷ EBT
c. EBIT ÷ Sales
d. EBIT ÷ Variables Cost

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6. Which of the following is correct?

a. CL = OL + FL
b. CL = OL – FL
c. OL = OL× FL
d. OL = OL ÷ FL

ANSWERS

1. a 2. b

3. d 4. a
5. b 6. c

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 ILLUSTRATIONS

Source : ICAI, SM (New) - (From Question No. 1 - 3 )

Question 1

A Company produces and sells 10,000 shirts. The selling price per shirt is ` 500. Variable
cost is ` 200 per shirt and fixed operating cost is ` 25,00,000.
a. Calculate operating leverage.
b. If sales are up by 10%, then what is the impact on EBIT?

Answer :

a. Statement of Profitability
Particulars (`)
Sales Revenue (10,000 × 500) 50,00,000
Less: Variable Cost (10,000 × 200) 20,00,000
Contribution 30,00,000
Less: Fixed Cost 25,00,000

EBIT 5,00,000

Contribution ` 30 lakhs
Operating Leverage =   6 times
EBIT ` 5 lakhs

% Change in EBIT
b. Operating Leverage (OL) 
% Change in Sales
X/ 5, 00, 000
6 =
5, 00, 000 / 50, 00, 000
X = ` 3,00,000
∴ ∆ EBIT = ` 3,00,000/5,00,000
= 60%

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Question 2

Calculate the operating leverage for each of the four firms A, B, C and D from the following
price and cost data:
Firms
A (`) B (`) C (`) D (`)
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil

What calculations can you draw with respect to levels of fixed cost and the degree
of operating leverage result? Explain. Assume number of units sold is 5,000.

Answer :

Firms
Particulars
A B C D
Sales (units) 5,000 5,000 5,000 5,000
Sales revenue (Units × price) (`) 1,00,000 1,60,000 2,50,000 3,50,000
Less: Variable cost (30,000) (80,000) (1,00,000) (2,50,000)
(Units × variable cost per unit) (`)
Less: Fixed operating costs (`) (60,000) (40,000) (1,00,000) Nil
EBIT 10,000 40,000 50,000 1,00,000

Current sales (S) - Variable costs (VC)

DOL 
Current EBIT
` 1,00,000- ` 30,000
DOL A  = 7
` 10, 000
` 1,60,000- ` 80,000
DOL  B  = 2
` 40, 000
` 2,50,000- ` 1,00,000
DOL  C  = 3
` 50, 000
` 3,50,000- ` 2,50,000
DOL  D  = 1
` 1, 00, 000
The operating leverage exists only when there are fixed costs. In the case of firm D, there is
no magnified effect on the EBIT due to change in sales. A 20 per cent increase in sales has
resulted in a 20 per cent increase in EBIT. In the case of other firms, operating leverage

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exists. It is maximum in firm A, followed by firm C and minimum in firm B. The

interception of DOL of 7 is that1 per cent change in sales results in 7 per cent change in
EBIT level in the direction of the change of sales level of firm A.

Question 3

A firm’s details are as under:

Sales (@100 per unit) ` 24,00,000
Variable Cost 50%
Fixed Cost ` 10,00,000
It has borrowed ` 10,00,000 @ 10% p.a. and its equity share capital is ` 10,00,000 (` 100 each)

Calculate:
a. Operating Leverage
b. Financial Leverage
c. Combined Leverage
d. Return on Investment
e. If the sales increases by ` 6,00,000; what will the new EBIT?

Answer :

Particulars (`)
Sales 24,00,000
Less: Variable cost 12,00,000
Contribution 12,00,000
Less: Fixed cost 10,00,000
EBIT 2,00,000
Less: Interest 1,00,000
EBT 1,00,000
Less: Tax (50%) 50,000
EAT 50,000
No. of equity shares 10,000
EPS 5

12,00,000
a. Operating Leverage =  6 times
2,00,000
2,00,000
b. Financial Leverage =  2 times
1,00,000

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c. Combined Leverage = OL × FL = 6 × 2 = 12 times.

50, 000
d. R.O.I   100  5%
10, 00, 000
EAT - Pref. Dividend
Here ROI is calculated as ROE i.e. =
Equity shareholders 'fund

e. Operating Leverage = 6
EBIT
6=
0.25
61
∆ EBIT =  1.5
4
Increase in EBIT = ` 2,00,000 × 1.5 = ` 3,00,000
New EBIT = 5,00,000

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 PRACTICE QUESTIONS

Source : ICAI, SM (New) - (From Question No. 1 - 4 )

Question 1

Suppose there are two firms with the same operating leverage, business risk, and
probability distribution of EBIT and only differ with respect to their use of debt
(capital structure).

Firm U Firm L
No debt ` 10,000 of 12% debt
` 20,000 in assets ` 20,000 in assets
40% tax rate 40% tax rate

Answer :

Firm U: Unleveraged
Economy
Bad Avg. Good
Probability 0.25 0.50 0.25
EBIT ` 2,000 ` 3,000 ` 4,000
Interest 0 0 0
EBIT ` 2,000 ` 3,000 ` 4,000
Taxes (40%) 800 1,200 1,600
NI 1,200 ` 1,800 ` 2,400

Firm L: Leveraged
Economy
Bad Avg. Good
Probability 0.25 0.50 0.25
EBIT ` 2,000 ` 3,000 ` 4,000
Interest 1,200 1,200 1,200
EBIT ` 800 ` 1,800 ` 2,800
Taxes (40%) 320 720 1,120
NI ` 480 `1,080 ` 1,680
*Same as for Firm U.
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Ratio comparison between leveraged and unleveraged firms

Firm U Bad Avg. Good
BEP = (EBIT /TOTAL ASSETS) 10.0% 15.0% 20.0%
ROE = (PAT/ NETWORTH) 6.0% 9.0% 12.0%
TIE = (INTEREST COVERAGE ∞ ∞ ∞
RATIO = (EBIT/ INTEREST)
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67% 2.50% 3.30%

Risk and return for leveraged and unleveraged firms

Expected Values:
Firm U Firm L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) ∞ 2.5x

Risk Measures:
Firm U Firm L
σROE 2.12% 4.24%
CVROE 0.24 0.39

Thus, the effect of leverage on profitability and debt coverage can be seen from the above
example. For leverage to raise expected ROE, BEP must be greater than K d i.e. BEP > Kd
because if Kd > BEP, then the interest expense will be higher than the operating income
produced by debt-financed assets, so leverage will depress income. As debt increases, TIE
decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = K d).

Thus, it can be concluded that the basic earning power (BEP) is unaffected by
financial leverage. Firm L has higher expected ROE because BEP > K d and it has much
wider ROE (and EPS) swings because of fixed interest charges. Its higher expected
return is accompanied by higher risk.

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Question 2

Betatronics Ltd. has the following balance sheet and income statement information:

Balance Sheet as on March 31st

Liabilities (`) Assets (`)
Equity capital (` 10 per 8,00,000 Net fixed assets 10,00,000
share)
10% Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000

Income Statement for the year ending March 31

(`)
Sales 3,40,000
Operating expenses (including ` 60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: Interest 60,000
Earnings before tax 1,60,000
Less: Taxes 56,000
Net Earnings (EAT) 1,04,000

a. Determine the degree of operating, financial and combined leverages at the

current sales level, if all operating expenses, other than depreciation, are variable costs.
b. If total assets remain at the same level, but sales (i) increase by 20 percent and (ii)
decrease by 20 percent, what will be the earnings per share at the new sales level?

Answer :

a. Calculation of Degree of Operating (DOL), Financial (DFL) and Combined

leverages (DCL).
` 3, 40, 000  ` 60, 000
DOL   1.27
` 2, 20, 000
` 2, 20, 000
DFL   1.38
` 1, 60, 000
DCL = DOL×DFL = 1.27×1.38 = 1.75

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b. Earnings per share at the new sales level

Increase by 20% Decrease by 20%

(`) (`)
Sales level 4,08,000 2,72,000
Less: Variable expenses 72,000 48,000
Less: Fixed cost 60,000 60,000
Earnings before interest and taxes 2,76,000 1,64,000
Less: Interest 60,000 60,000
Earnings before taxes 2,16,000 1,04,000
Less: Taxes 75,600 36,400
Earnings after taxes (EAT) 1,40,400 67,600
Number of equity shares 80,000 80,000
EPS 1.76 0.85

Working Notes:
i. Variable Costs = ` 60,000 (total cost − depreciation)
ii. Variable Costs at:
a. Sales level, ` 4,08,000 = ` 72,000 (increase by 20%)
b. Sales level, ` 2,72,000 = ` 48,000 (decrease by 20%)

Question 3

A company had the following Balance Sheet as on 31st March, 2014:

(` in (` in
Liabilities Assets
crores) crores)
Equity Share Capital (50 lakhs 5
shares of ` 10 each)
Reserves and Surplus 1 Fixed Assets (Net) 12.5
15% Debentures 10 Current Assets 7.5
Current Liabilities 4
20 20

The additional information given is as under:

Fixed cost per annum (excluding interest) ` 4 crores
Variable operating cost ratio 65%
Total assets turnover ratio 2.5
Income Tax rate 30%

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Required:
Calculate the following and comment:
i. Earnings Per Share
ii. Operating Leverage
iii. Financial Leverage
iv. Combined Leverage

Answer :

Total Assets = ` 20 crores

Total Asset Turnover Ratio = 2.5
Hence, Total Sales = 20 × 2.5 = ` 50 crores

Computation of Profit after Tax (PAT)

(` in crores)
Sales 50.00
Less: Variable Operating Cost @ 65% 32.50
Contribution 17.50
Less: Fixed Cost (other than Interest) 4.00
EBIT 13.50
Less: Interest on Debentures (15% × 10) 1.50
PBT 12.00
Less: Tax @ 30% 3.60
PAT 8.40

i. Earnings per Share

5.40 crores 8.40 crores
EPS   = ` 16.80
Number of Equity Shares 50,00,000
It indicates the amount the company earns per share. Investors use this as a guide while
valuing the share and making investment decisions. It is also a indicator used in
comparing firms within an industry or industry segment.

ii. Operating Leverage

Contribution 17.50
Operating Leverage =   1.296
EBIT 12.00
It indicates the choice of technology and fixed cost in cost structure. It is level specific.
When firm operates beyond operating break-even level, then operating leverage is low.
It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a
particular level.
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iii. Financial Leverage

EBIT 13.50
Financial Leverage =   1.125
PBT 12.00
The financial leverage is very comfortable since the debt service obligation is small vis-
à-vis EBIT.

iv. Combined Leverage

Contribution EBIT
Combined Leverage= 
EBIT PBT
Or, = Operating Leverage × Financial Leverage
= 1.296 × 1.125 = 1.458
The combined leverage studies the choice of fixed cost in cost structure and choice of
debt in capital structure. It studies how sensitive the change in EPS is vis-à-vis change
in sales. The leverages − operating, financial and combined are measures of risk.

Question 4

Calculate the operating leverage, financial leverage and combined leverage from the
following data under Situation I and II and Financial Plan A and B:
Installed Capacity 4,000 units
Actual Production and Sales 75% of the Capacity
Selling Price ` 30 Per Unit
Variable Cost ` 15 Per Unit

Fixed Cost:
Under Situation I ` 15,000
Under Situation-II `20,000

Capital Structure:
Financial Plan
A (`) B (`)
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000

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Answer :

Particulars Situation-I Situation-II

(`) (`)
Sales (S)
90,000 90,000
3000 units @ ` 30/- per unit
Less: Variable Cost (VC) @ ` 15 per unit 45,000 45,000
Contribution (C) 45,000 45,000
Less: Fixed Cost (FC) 15,000 20,000
Operating Profit (OP) 30,000 25,000
(EBIT)

i. Operating Leverage
C 45, 000 45, 000
` `
OP 30, 000 25, 000
= 1.5 1.8

ii. Financial Leverages

A B
(`) (`)
Situation I
Operating Profit (EBIT) 30,000 30,000
Less: Interest on debt 2,000 1,000
PBT 28,000 29,000

OP 30, 000 30, 000

Financial Leverage = `  1.07 `  1.04
PBT 28, 000 24, 000

A B
(`) (`)
Situation-II
Operating Profit (OP) 25,000 25,000
(EBIT)
Less: Interest on debt 2,000 1,000
PBT 23,000 24,000

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Source : ICAI, Compilation (Old) - (From Question No. 5 -19 )

Question 5

The following summarises the percentage changes in operating income, percentage changes
in revenues, and betas for four pharmaceutical firms.
Firm Change in revenue Change in operating income Beta
PQR Ltd. 27% 25% 1.00
RST Ltd. 25% 32% 1.15
TUV Ltd. 23% 36% 1.30
WXY Ltd. 21% 40% 1.40

Required:
i. Calculate the degree of operating leverage for each of these firms. Comment also.
ii. Use the operating leverage to explain why these firms have different beta.

Answer :

% Change in Operating income

i. Degree of operating leverage 
% Change in Revenues
PQR Ltd. = 25% / 27% = 0.9259
RST Ltd. = 0.32 / 0.25 = 1.28
TUV Ltd. = 0.36 /0.23 = 1.5652
WXY Ltd. = 0.40/ 0.21 = 1.9048
It is level specific.

ii. High operating leverage leads to high beta. The sources of risk are the cyclic
nature revenues, operating risk and financial risk.

Question 6

A Company had the following Balance Sheet as on March 31, 2006:

Liabilities and Equity ` (in crores) Assets ` (in crores)
Equity Share Capital
10 Fixed Assets (Net) 25
(one crore shares of ` 10 each)
Reserves and Surplus 2 Current Assets 15
15% Debentures 20
Current Liabilities 8
40 40

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The additional information given is as under:

Fixed Costs per annum (excluding interest) ` 8 crores
Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%

Required:
Calculate the following and comment:
i. Earnings per share
ii. Operating Leverage
iii. Financial Leverage
iv. Combined Leverage

Answer :

Total Assets = ` 40 crores

Total Asset Turnover Ratio = 2.5
Hence, Total Sales = 40  2.5 = ` 100 crores

Computation of Profits after Tax (PAT)

(` in crores)
Sales 100
Less: Variable operating cost @ 65% 65
Contribution 35
Less: Fixed cost (other than Interest) 8
EBIT 27
Less: Interest on debentures (15%  20) 3
PBT 24
Less: Tax 40% 9.6
PAT 14.4

i. Earnings per share

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ii. Operating Leverage

Contribution 35
Operating leverage = = = 1.296
EBIT 27
It indicates the choice of technology and fixed cost in cost structure. It is level specific.
When firm operates beyond operating break-even level, then operating leverage is
low. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales
at a particular level.

iii. Financial Leverage

EBIT 27
Financial Leverage = = = 1.125
PBT 24
The financial leverage is very comfortable since the debt service obligation is small vis-
à- vis EBIT.

iv. Combined Leverage

Contribution EBIT
Combined Leverage= 
EBIT PBT
= 1.296  1.125
= 1.458
The combined leverage studies the choice of fixed cost in cost structure and
choice of debt in capital structure. It studies how sensitive the change in EPS is vis-à-
vis change in sales.
The leverages - operating, financial and combined are measures of risk.

Question 7

The following details of RST Limited for the year ended 31March, 2006 are given below:
Operating leverage 1.4
Combined leverage 2.8
Fixed Cost (Excluding interest) ` 2.04 lakhs
Sales ` 30.00 lakhs
12% Debentures of ` 100 each ` 21.25 lakhs
Equity Share Capital of ` 10 each ` 17.00 lakhs
Income tax rate 30 per cent

Required:
i. Calculate Financial leverage
ii. Calculate P/V ratio and Earning per Share (EPS)

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iii. If the company belongs to an industry, whose assets turnover is 1.5, does it have a high
or low assets leverage?
iv. At what level of sales the Earning before Tax (EBT) of the company will be equal to
zero?

Answer :

i. Financial leverage
Combined Leverage = Operating Leverage (OL)  Financial Leverage (FL)
2.8 = 1.4  FL
FL =2
Financial Leverage =2

ii. P/V Ratio and EPS

C
P / V ratio   100
S
C
Operating leverage =  100
CF
C
1.4 
C  2, 04, 000
1.4 (C – 2,04,000) = C
1.4 C – 2,85,600 = C
2,85,600
C
0.4
C = 7,14,000
7,14,000
P /V   100  23.8%
30,00,000
Therefore, P/V ratio = 23.8%
Profit after tax
EPS 
No. of equity shares
EBT = Sales – V – FC – Interest
= 30,00,000 – 22,86,000 – 2,04,000 – 2,55,000 = 2,55,000
PAT = EBT – Tax
= 2,55,000 – 76,500 = 1,78,500
1,78,500
EPS =  1.05
1,70,000

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iii. Assets Turnover

Sales 30,00,000
Assets turnover =  =0 .784
Total Assets 38,25,000
0.784 < 1.5 means lower than industry turnover.

iv. EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales have to be
dropped by 100/2.8 = 35.71%. Hence new sales will be
30,00,000  (100 – 35.71) = 19,28,700.
Therefore, at 19,28,700 level of sales, the Earnings before Tax of the company will
be equal to zero.

Question 8

A firm has Sales of ` 40 lakhs; Variable cost of ` 25 lakhs; Fixed cost of ` 6 lakhs; 10% debt
of ` 30 lakhs; and Equity Capital of ` 45 lakhs.
Required Calculate operating and financial leverage.

Answer :

Calculation of Operating and Financial Leverage

`
Sales 40,00,000
Less: Variable cost 25,00,000
Contribution (C) 15,00,000
Less: Fixed cost 6,00,000
EBIT 9,00,000
Less: Interest 3,00,000
EBT 6,00,000

C 15,00,000
Operating leverage =   1.67
EBIT 9,00,000
EBIT 9,00,000
Financial leverage =   1.50
EBT 6,00,000

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Question 9

The following data relate to RT Ltd:

`
Earnings before interest and tax 10,00,000
(EBIT) Fixed cost 20,00,000
Earnings Before Tax (EBT) 8,00,000

Required:
Calculate combined leverage.

Answer :

Contribution:
C = S – V and
EBIT =C-F
10,00,000 = C – 20,00,000
∴C = 30,00,000
Operating leverage = C / EBIT = 30,00,000/10,00,000 = 3 times
Financial leverage = EBIT/EBT = 10,00,000/8,00,000 = 1.25 times
Combined leverage = OL  FL = 3 x 1.25 = 3.75 times

Question 10

A company operates at a production level of 1,000 units. The contribution is ` 60 per unit,
operating leverage is 6, and combined leverage is 24. If tax rate is 30%, what would
be its earnings after tax?

Answer :

Computation of Earnings after tax

Contribution = ` 60  1,000 = ` 60,000
Operating Leverage (OL)  Financial Leverage (FL) = Combined Leverage (CL)
6  Financial Leverage = 24
∴ Financial Leverage = 4
Contribution 60,000
Operating Leverage  = 6
EBIT EBIT
60,000
∴ EBIT  10, 000
6
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EBIT
FL  4
EBT

Since tax rate = 30%

Earnings after Tax (EAT) = EBT (1 − 0.30)
= 2,500 (0.70)
∴ Earning After Tax (EAT) = 1,750

Question 11

From the following financial data of Company A and Company B: Prepare their
Income Statements.
Company A Company B
` `
Variable Cost 56,000 60% of sales
Fixed Cost 20,000 -
Interest Expenses 12,000 9,000
Financial Leverage 5:1 -
Operating Leverage - 4:1
Income Tax Rate 30% 30%
Sales - 1,05,000

Answer :

Income Statements of Company A and Company B

Company A Company B
` `
Sales 91,000 1,05,000
Less: Variable cost 56,000 63,000
Contribution 35,000 42,000
Less: Fixed Cost 20,000 31,500
Earnings before interest and tax (EBIT) 15,000 10,500
Less: Interest 12,000 9,000
Earnings before tax (EBT) 3,000 1,500
Less: Tax @ 30% 900 450
Earnings after tax (EAT) 2,100 1,050

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Working Notes:

Company A
EBIT
i. Financial Leverage =
EBIT  Interest
EBIT
5 =
EBIT - 12,000
5 (EBIT – 12,000) = EBIT
4 EBIT = 60,000
EBIT = `15,000

ii. Contribution = EBIT + Fixed Cost

= 15,000 + 20,000 = ` 35,000

iii. Sales = Contribution + Variable cost

= 35,000 + 56,000 = ` 91,000

Company B

i. Contribution = 40% of Sales (as Variable Cost is 60% of Sales)

= 40% of 1,05,000 = ` 42,000

Contribution
ii. Financial Leverage =
EBIT
42,000
4 =
EBIT
42, 000
EBIT = ` 10, 500
4

iii. Fixed Cost = Contribution – EBIT = 42,000 – 10,500 = ` 31,500

Question 12

Calculate the degree of operating leverage, degree of financial leverage and the degree of
combined leverage for the following firms and interpret the results:
P Q R
Output (units) 2,50,000 1,25,000 7,50,000
Fixed Cost (`) 5,00,000 2,50,000 10,00,000
Unit Variable Cost (`) 5 2 7.50
Unit Selling Price (`) 7.50 7 10.0
Interest Expense (`) 75,000 25,000 -

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Answer :

Estimation of Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL)

and Degree of Combined Leverage (DCL)
P Q R
Output (in units) 2,50,000 1,25,000 7,50,000
Selling Price (per unit) 7.50 7 10

Sales Revenues 18,75,000 8,75,000 75,00,000

Less: Variable Cost 12,50,000 2,50,000 56,25,000

Contribution Margin 6,25,000 6,25,000 18,75,000

Less: Fixed Cost 5,00,000 2,50,000 10,00,000
EBIT 1,25,000 3,75,000 8,75,000
Less: Interest Expense 75,000 25,000 -

EBT 50,000 3,50,000 8,75,000

5x 1.67 x 2.14 x

2.5 x 1.07 x 1.00 x

DCL = DOL× DFL

12.5 x 1.79 x 2.14 x
Moderate
Policy
Aggressive Moderate
Comment with no
Policy Policy
financial
leverage

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Question 13

You are given two financial plans of a company which has two financial situations.
The detailed information are as under:
Installed capacity 10,000 units
Actual production and sales 60% of installed capacity
Selling price per unit ` 30
Variable cost per unit ` 20
Fixed cost:
Situation ‘A’ = ` 20,000
Situation ‘B’ = ` 25,000
Capital structure of the company is as follows:
Financial Plans
XY XM
` `
Equity 12,000 35,000
Debt (cost of debt 12%) 40,000 10,000
52,000 45,000
You are required to calculate operating leverage and financial leverage of both the plans.

Answer :

Computation of Operating and Financial Leverage

Actual Production and Sales: 60% of 10,000 = 6,000 units
Contribution per unit: ` 30 – ` 20 = ` 10
Total Contribution: 6,000  ` 10 = ` 60,000
Financial Plan XY XM
Situation A B A B
` ` ` `
Contribution 60,000 60,000 60,000 60,000
Less: Fixed Cost 20,000 25,000 20,000 25,000
Operating Profit or EBIT 40,000 35,000 40,000 35,000
Less: Interest 4,800 4,800 1,200 1,200
Earnings before tax (EBT) 35,200 30,200 38,800 33,800
C 60, 000 60, 000 60, 000 60, 000
Operating Leverage = =1.5 =1.71 =1.5 =1.71
EBIT 40, 000 35, 000 40, 000 35, 000
EBIT 40, 000 35, 000 40, 000 35, 000
Financial Leverage   1.14  1.16  1.03  1.04
EBT 35, 200 30, 200 38, 800 33, 800

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Question 14

Alpha Ltd. has furnished the following Balance Sheet as on March 31, 2011:
Liabilities ` Assets `
Equity Share Capital 10,00,000
(1,00,000)equity shares of ` 10 each) Fixed Assets 30,00,000

General Reserve 2,00,000 Current Assets 18,00,000

15% Debentures 28,00,000
Current Liabilities 8,00,000
48,00,000 48,00,000

Additional Information:
1 Annual Fixed Cost other than Interest 28,00,000
2 Variable Cost Ratio 60%
3 Total Assets Turnover Ratio 2.5
4 Tax Rate 30%

You are required to calculate:

i. Earnings per Share (EPS), and
ii. Combined Leverage

Answer :

Total Assets = ` 48,00,000

Total Assets Turnover Ratio = 2.5
Total Sales = 48,00,000 × 2.5 = ` 1,20,00,000

Computation of Profit after Tax (PAT)

Particulars Amount
Sales 1,20,00,000
Less: Variable Cost ( 60% of Sales Contribution) 72,00,000
Contribution 48,00,000
Less: Fixed Cost (other than Interest) 28,00,000
20,00,000
Less: Interest on Debentures (15% of 28,00,000) 4,20,000
PBT 15,80,000
Less: Tax @ 30% 4,74,000
PAT 11,06,000

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CA INTER FINANCIAL MANAGEMENT

PAT
i. EPS 
No. of Equity Shares
11,06,000
= ` 11.06
1,00,000

Contribution EBIT
ii. DCL  
EBIT PBT
Contribution
Or, =
PBT

Question 15

The capital structure of JCPL Ltd. is as follows:

`
Equity share capital of ` 10 each 8,00,000
8% Preferences share capital of ` 10 each 6,25,000
10% Debenture of ` 100 each 4,00,000
18,25,000

Additional Information:
Profit after tax (tax rate 30%) ` 1,82,000
Operating expenses (including depreciation ` 90,000) being 1.50 times of EBIT
Equity share dividend paid 15%.
Market price per equity share` 20.

Require to calculate:
i. Operating and financial leverage.
ii. Cover for the preference and equity share of dividends.
iii. The earning yield and price earnings ratio.
iv. The net fund flow.

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 FINANCING DECISIONS- LEVERAGES

Answer :

[Assumption: All operating expenses (excluding depreciation) are variable]

Working Notes
`
Net profit after tax 1,82,000
Tax @ 30% 78,000
EBT 2,60,000
Interest on debenture 40,000
EBIT 3,00,000
Operating Expenses 1.50 times 4,50,000
Sales 7,50,000

i. Operating Leverage = Contribution/EBIT

= (7,50,000 - 3,60,000) / 3,00,000
= 3,90,000 / 3,00,000 = 1.30 times.
Financial Leverage = EBIT / EBT = 3,00,000 / 2,60,000 = 1.15 times
OR
 Pref Dividend 
FL = EBIT + EBT -  
 1t 

ii. Preference Dividend Cover = PAT / Preference share Dividend

= (1,82,000 / 50,000) = 3.64 times
Equity dividend cover = PAT - Pref. div / Equity dividend
= (1,82,000 - 50,000) / 1,20,000= 1.10 times

iii. Earning yield = EPS / Market price  100 i.e.

= 1,32,000 / 80,000 = 1.65 / 20 = 8.25%
Price Earnings Ratio = Market price / EPS = 20 / 1.65 = 12.1 Times

iv. Net Funds Flow

Net Funds flow = Net profit after tax + depreciation – Total dividend
= 1,82,000 + 90,000 – (50,000 + 1,20,000)
= 2,72,000 – 1,70,000
Net funds flow = 1,02,000

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Question 16

X Limited has estimated that for a new product its break-even point is 20,000 units if the
item is sold for ` 14 per unit and variable cost ` 9 per unit. Calculate the degree of
operating leverage for sales volume 25,000 units and 30,000 units.

Answer :

Computation of Degree of Operating Leverage (DOL)

Selling Price = ` 14 per unit
Variable Cost = ` 9 per unit
Fixed Cost = BEP x (Selling price – Variable cost) = 20,000 x (14 - 9) = 20,000 x 5 = 1,00,000
` (For 25,000 units) ` (For 30,000 units)
Sales ( @ `14 /unit) 3,50,000 4,20,000
Less: Variable Cost (@ 9 unit ) 2,25,000 2,70,000
Contribution 1,25,000 1,50,000
Less: Fixed Cost 1,00,000 1,00,000
EBIT 25,000 50,000

DOL 5 times 3 times

Question 17

The following information related to XL Company Ltd. for the year ended 31st March, 2013
are available to you:
Equity share capital of ` 10 each ` 25 lakh
11% Bonds of `1000 each ` 18.5 lakh
Sales ` 42 lakh
Fixed cost (Excluding Interest) ` 3.48 lakh
Financial leverage 1.39
Profit-Volume Ratio 25.55%
Income Tax Rate Applicable 35%

You are required to calculate:

i. Operating Leverage;
ii. Combined Leverage; and
iii. Earning per share

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 FINANCING DECISIONS- LEVERAGES

Answer :

Contribution
Profit - Volume Ratio =
Sales

Contribution
25.55 =  100
42,00,000

Contribution = 10,73,100

Contribution
i. Operating Leverage =
Contribution - Fixed Cost

ii. Combined Leverage = Operating Leverage x Financial Leverage

=1.48  1.39 = 2.06

iii. Earnings per Share (EPS)

Number of Equity Shares = 2,50,000
Earnings before Tax (EBT) = Sales – Variable Cost – Fixed Cost – Interest
= 42,00,000 – 31,26,900 –3,48,000 –2,03,500
EBT = 5,21,600

Profit after Tax (PAT) = EBT – Tax

= 5, 21,600 – 1,82,560
= 3,39,040
3,39,040
EPS =  1.3561
2,50,000
EPS = 1.36

Question 18

Calculate the degree of operating leverage, degree of financial leverage and the
degree of combined leverage for the following firms:
N S D
Production (in units) 17,500 6,700 31,800
Fixed costs ` 4,00,000 3,50,000 2,50,000
Interest on loan ` 1,25,000 75,000 Nil
Selling price per unit ` 85 130 37
Variable cost per unit ` 38.00 42.50 12.00
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Answer :

Computation of Degree of Operating Leverage (DOL), Degree of Financial Leverage

(DFL) and Degree of Combined Leverage (DCL)

Firm N Firm S Firm D

Output (Units) 17,500 6,700 31,800
Selling Price/Unit 85 130 37
Sales Revenue (A) 14,87,500 8,71,000 11,76,600
Variable Cost/Unit 38.00 42.50 12.00
Less: Variable Cost (B) 6,65,000 2,84,750 3,81,600
Contribution (A-B) 8,22,500 5,86,250 7,95,000
Less: Fixed Cost 4,00,000 3,50,000 2,50,000
EBIT 4,22,500 2,36,250 5,45,000
Less: Interest on Loan 1,25,000 75,000 -
PBT 2,97,500 1,61,250 5,45,000
C 8,22,500 5,86,250 7,95,000
DOL  = 1.95 = 2.48 = 1.46
EBIT 4,22,500 2,36,250 5,45,000
EBIT 4,22,500 2,36,250 5,45,000
DFL  = 1.42 = 1.47 = 1.00
PBT 2,97,500 1,61,250 5,45,000
DCL = OL × FL 1.95  1.42= 2.77 2.48  1.47= 3.65 1.46  1= 1.46
OR
Contribution 8,22,500 5,86,250 7,95,000
DCL   2.76 = 3.64 = 1.46
PBT 2,97,500 1,61,250 5,45,000

Question 19

The Capital structure of RST Ltd. is as follows:

`
Equity Share of ` 10 each 8,00,000
10% Preference Share of ` 100 each 5,00,000
12% Debentures of ` 100 each 7,00,000
20,00,000

Additional Information:
- Profit after tax (Tax Rate 30%) are ` 2,80,000
- Operating Expenses (including Depreciation ` 96,800) are 1.5 times of EBIT
- Equity Dividend paid is 15%
- Market price of Equity Share is ` 23
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 FINANCING DECISIONS- LEVERAGES

Calculate:
i. Operating and Financial Leverage
ii. Cover for preference and equity dividend
iii. The Earning Yield Ratio and Price Earning Ratio
iv. The Net Fund Flow

Note: All operating expenses (excluding depreciation) are variable.

Answer :

Working Notes:

`
Net Profit after Tax 2,80,000
Tax @ 30% 1,20,000
EBT 4,00,000
Interest on Debentures 84,000
EBIT 4,84,000
Operating Expenses (1.5 times of EBIT) 7,26,000
Sales 12,10,000

Contribution
i. Operating Leverage =
EBIT
(12,10,000 - 6,29,200)
=
4,84,000
5,80,800
=  1.2 times
4,84,000
EBIT
Financial Leverage=
EBT
4,84,000
=  1.21 times
4,00,000
OR

4,84,000
=
 50, 000 
4,00,000 -  
 1  0.30 

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4,84,000
=
4,00,000 - 71,428.57
4,84,000
=  1.47 times
3,28,571

ii. Cover for Preference Dividend

PAT 2,80,000
=  5.6 times
Preference Share Dividend 50,000

Cover for Equity Dividend

(PAT - Preference Dividend)
=
Equity Share Dividend
(2,80,000 - 50,000) 2,30,000
=   1.92 times
1,20,000 1,20,000

EPS
iii. Earning Yield Ratio =  100
Market Price

2.875
=  100  12.5%
23
Price – Earnings Ratio (PE Ratio)

= 8 times

iv. Net Funds Flow

= Net PAT + Depreciation-Total Dividend
= 2,80,000 + 96,800 – (50,000 + 1,20,000)
= 3,76,800 – 1,70,000
Net Funds Flow = 2,06,800

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 FINANCING DECISIONS- LEVERAGES

Source : ICAI, PM (Old) - (From Question No. 20 - 32)

Question 20

Consider the following information for Omega Ltd.:

` in lakhs
EBIT (Earnings before Interest and Tax) 15,750
Earnings before Tax (EBT): 7,000
Fixed Operating costs: 1,575

Required:
Calculate percentage change in earnings per share, if sales increase by 5%.

Answer :

Operating Leverage (OL)

Contribution EBIT + Fixed Cost ` 15,750 + ` 1,575
=    1.1
EBIT EBIT 15,750

Financial Leverage (FL)

Combined Leverage (CL)

= 1.1  2.25 = 2.475

Percentage Change in Earnings per share

% change in EPS
DCL 
% change in Sales

∴ % change in EPS = 12.375%.

Hence if sales is increased by 5%, EPS will be increased by 12.375%.

Question 21

A company operates at a production level of 5,000 units. The contribution is ` 60 per unit,
operating leverage is 6, combined leverage is 24. If tax rate is 30%, what would be its
earnings after tax?

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Answer :

Answer Computation of Earnings after tax (EAT) or Profit after tax (PAT)
Total contribution = 5,000 units x ` 60/unit = ` 3,00,000
Operating leverage (OL)  Financial leverage (FL) = Combined leverage (CL)
∴ 6 × FL = 24 ∴ FL = 4

EBIT ` 50,000
FL  ∴ 4 ∴ EBT = ` 12,500
EBT EBT
Since tax rate is 30%, therefore, Earnings after tax = 12,500  0.70 = ` 8,750 Earnings after tax
(EAT) = ` 8,750

Question 22

A firm has Sales of ` 40 lakhs; Variable cost of ` 25 lakhs; Fixed cost of ` 6 lakhs; 10% debt
of ` 30 lakhs; and Equity Capital of ` 45 lakhs.

Required:
Calculate operating and financial leverage.

Answer :

Calculation of Operating and Financial Leverage

`
Sales 40,00,000
Less: Variable cost 25,00,000
Contribution (C) 15,00,000
Less: Fixed cost 6,00,000
EBIT 9,00,000
Less: Interest 3,00,000
EBT 6,00,000

C ` 15,00,000
Operating leverage =   1.67
EBIT ` 9,00,000
EBIT ` 9,00,000
Financial leverage =   1.50
EBT ` 6,00,000

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Question 23

Consider the following information for Strong Ltd:

` in lakh
EBIT 1,120
PBT 320
Fixed Cost 700

Calculate the percentage of change in earnings per share, if sales increased by 5 per cent.

Answer :

Percentage change in earning per share to the percentage change in sales is calculated
through degree of combined leverage,.
Hence, Computation of percentage of change in earnings per share, if sales increased by 5%
% change in Earning per share (EPS)
Degree of Combined leverage(DCL) =
% change in sales
Moreover, Degree of operating leverage (DOL) × Degree of Financial Leverage (DFL) =
Degree of combined leverage (DCL)
% change in Earning per share (EPS)
Or, DOL × DFL =
% change in sales
% change in Earning per share (EPS)
Or, 1.625 × 3.5 [Refer to working notes (i) and (ii)] =
5
% change in Earning per share (EPS)
Or, 5.687 =
5
Or, % change in EPS = 5.687 × 5= 28.4375%
So, If sales is increased by 5 percent, Percentage of change in earning per share will be
28.4375 %

Working Notes:

Contribution ( ` 1,120 + `700 lakhs)

i. Degree of operating leverage (DOL) =   1.625
EBIT ` 1, 120 lakhs
EBIT ` 1, 120
ii. Degree of financial leverage (DFL) =   3.5
PBT ` 320

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Question 24

The data relating to two companies are given below :

Company A Company B
Equity Capital ` 6,00,000 ` 3,50,000
12% Debentures ` 4,00,000 ` 6,50,000
Output (units) per annum 60,000 15,000
Selling price/ unit ` 30 ` 250
Fixed Costs per annum ` 7,00,000 ` 14,00,000
Variable Cost per unit ` 10 ` 75

You are required to calculate the Operating leverage, Financial leverage and
Combined leverage of two Companies.

Answer :

Computation of degree of Operating leverage, Financial leverage and Combined leverage

of two companies
Company A Company B
Output units per annum 60,000 15,000
(`) (`)
Selling price / unit 30 250
Sales revenue 18,00,000 37,50,000
(60,000 units  ` 30) (15,000 units  ` 250)
Less: Variable costs 6,00,000 11,25,000
(60,000 units  ` 10) (15,000 units  ` 75)
Contribution (C) 12,00,000 26,25,000
Less: Fixed costs 7,00,000 14,00,000
EBIT (Earnings before Interest and tax) 5,00,000 12,25,000
Less: Interest @ 12% on debentures 48,000 78,000
PBT 4,52,000 11,47,000

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 FINANCING DECISIONS- LEVERAGES

Operating Leverage = 2.4 2.14

Contribution (` 12,00,000/ 5,00,000) (` 26,25,000 / ` 12,25,000)
EBIT
EBIT 1.11 1.07
Financial Leverage =
PBT (` 5,00,000/ ` 4,52,000) (` 12,25,000 / ` 11,47,000)
Combined Leverage = DOL  DFL 2.66 2.29
(2.4  1.11) (2.14 1.07)

Question 25

The net sales of A Ltd. is ` 30 crores. Earnings before interest and tax of the company as a
percentage of net sales is 12%. The capital employed comprises ` 10 crores of
equity, ` 2 crores of 13% Cumulative Preference Share Capital and 15% Debentures of `
6 crores. Income-tax rate is 40%.
i. Calculate the Return-on-equity for the company and indicate its segments due to
the presence of Preference Share Capital and Borrowing (Debentures).
ii. Calculate the Operating Leverage of the Company given that combined leverage is 3.

Answer :

i. Net Sales : ` 30 crores

EBIT = 12% on sales = ` 3.6 crores
EBIT 3.6
Return on Capital Employed (pre-tax) =   100  20%
Capital Employed 10  2  6
After tax it will be = 20% (1 - 0.4)= 12 %.
Particulars ` in crores
EBIT 3.6
Less: Interest on Debt (15% of 6 crores) 0.9
EBT 2.7
Less : Tax @ 40% 1.08
EAT 1.62
Less : Preference dividend 0.26
Earnings available for Equity Shareholders 1.36
Return on equity = 1.36/10 × 100 = 13.6%

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Segments due to the presence of Preference Share capital and Borrowing

(Debentures)
Segment of ROE due to preference capital : (12% - 13%) × ` 2 Crore = - 2%
Segment of ROE due to Debentures: (12% - 9%) × ` 6 Crores = 18 %
Total= -2 % +18 % = 16 %
Cost of debenture (after tax) = 15% (1- 0.4) = 9 %

The weighted average cost of capital is as follows

Source Proportion Cost (%) WACC (%)
i. Equity 10/18 13.60 7.56
ii. Preference shares 2/18 13.00 1.44
iii. Debt 6/18 9.00 3.00
Total 12.00

EBIT 3.6
ii. Financial Leverage =  = 1.33
EBT 2.7
Combined Leverage = FL × OL
3
3 = 1.33 × OL Or, OL = Or, Operating Leverage = 2.26
1.33

Question 26

Annual sales of a company is ` 60,00,000. Sales to variable cost ratio is 150 per cent and
Fixed cost other than interest is ` 5,00,000 per annum. Company has 11 per cent
debentures of ` 30,00,000.
You are required to calculate the operating, Financial and combined leverage of the
company.

Answer :

Calculation of Leverages
Particulars (`)
Sales 60,00,000
 100 
Less: Variable Cost  Sales   40,00,000
 150 
Contribution 20,00,000
Less: Fixed Cost 5,00,000
EBIT 15,00,000
Less: Interest on Debentures 3,30,000
EBT 11,70,000

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 FINANCING DECISIONS- LEVERAGES

Contribution ` 20,00,000
Operating Leverage = =  1.3333
EBIT ` 15,00,000

EBIT ` 15,00,000
Financial Leverage = =  1.2821
EBT ` 11,70,000

Contribution
Combined Leverage = OL × FL or
EBT

Question 27

Delta Ltd. currently has an equity share capital of ` 10,00,000 consisting of 1,00,000
Equity share of ` 10 each. The company is going through a major expansion plan requiring
to raise funds to the tune of ` 6,00,000. To finance the expansion the management has
following plans:
Plan-I : Issue 60,000 Equity shares of ` 10 each.
Plan-II : Issue 40,000 Equity shares of ` 10 each and the balance through long-term
borrowing at 12% interest p.a.
Plan-III : Issue 30,000 Equity shares of ` 10 each and 3,000, 9% Debentures of ` 100
each.
Plan-IV : Issue 30,000 Equity shares of ` 10 each and the balance through 6% preference
shares.
The EBIT of the company is expected to be ` 4,00,000 p.a. assume corporate tax rate of 40%.

Required:
i. Calculate EPS in each of the above plans.
ii. Ascertain financial leverage in each plan.

Answer :

Sources of Capital Plan I Plan II Plan III Plan IV

Present Equity Shares 1,00,000 1,00,000 1,00,000 1,00,000
New Issue 60,000 40,000 30,000 30,000
Equity share capital (`) 16,00,000 14,00,000 13,00,000 13,00,000
No. of Equity shares 1,60,000 1,40,000 1,30,000 1,30,000
12% Long term loan (`) - 2,00,000 - -
9% Debentures (`) - - 3,00,000 -
6% Preference Shares (`) - - - 3,00,000

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Computation of EPS and Financial Leverage

Sources of Capital Plan I Plan II Plan III Plan IV
EBIT (`) 4,00,000 4,00,000 4,00,000 4,00,000
Interest on 12% Loan (`) - 24,000 - -
Interest on 9% debentures (`) - - 27,000 -
EBT (`) 4,00,000 3,76,000 3,73,000 4,00,000
Less : Tax@ 40% 1,60,000 1,50,400 1,49,200 1,60,000
EAT (`) 2,40,000 2,25,600 2,23,800 2,40,000
Less: Preference Dividends (`) - - - 18,000
a. Net Earnings available for 2,40,000 2,25,600 2,23,800 2,22,000
equity shares (`)
b. No. of equity shares 1,60,000 1,40,000 1,30,000 1,30,000
c. EPS (a ÷ b) ` 1.50 1.61 1.72 1.71
Financial leverage - 1.00 1.06 1.07 1.08
 EBIT   EBIT 
  or  
 EBIT  I   EBT * 

* EBT is Earnings before tax but after interest and preference dividend in case of Plan IV.

Comments: Since the EPS and financial leverage both are highest in plan III, the
management could accept it.

Question 28

Z Limited is considering the installation of a new project costing ` 80,00,000. Expected

annual sales revenue from the project is ` 90,00,000 and its variable costs are 60 percent of
sales. Expected annual fixed cost other than interest is ` 10,00,000. Corporate tax rate is 30
percent. The company wants to arrange the funds through issuing 4,00,000 equity shares of
` 10 each and 12 percent debentures of ` 40,00,000.

You are required to:

i. Calculate the operating, financial and combined leverages and Earnings per Share
(EPS).
ii. Determine the likely level of EBIT, if EPS is ` 4, or ` 2, or Zero.

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Answer :

i. Calculation of Leverages and Earnings per Share (EPS)

Income Statement
Particulars (`)
Sales Revenue 90,00,000
Less: Variable Cost @ 60% 54,00,000
Contribution 36,00,000
Less: Fixed Cost other than Interest 10,00,000
Earnings before Interest and Tax (EBIT) 26,00,000
Less: Interest (12% on ` 40,00,000) 4,80,000
Earnings before tax (EBT) 21,20,000
Less: Tax @ 30% 6,36,000
Earnings after tax (EAT)/ Profit after tax (PAT) 14,84,000

1. Calculation of Operating Leverage (OL)

2. Calculation of Financial Leverage (FL)

3. Calculation of Combined Leverage (CL)

Combined Leverage = OL × FL = 1.3846 × 1.2264 = 1.6981

4. Calculation of Earnings per Share (EPS)

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ii. Calculation of likely levels of EBIT at Different EPS

(EBIT - I)(1- T)
EPS 
Number of Equity Shares
1. If EPS is ` 4

EBIT – ` 4,80,000 = ` 22,85,714 Or, EBIT = ` 27, 65,714

2. If EPS is ` 2

EBIT – ` 4,80,000 = ` 11,42,857 Or, EBIT = ` 16, 22,857

3. If EPS is ` Zero

Question 29

Following information are related to four firms of the same industry:

Firm Change in Revenue Change in Operating Change in Earning per
Income Share
P 27% 25% 30%
Q 25% 32% 24%
R 23% 36% 21%
S 21% 40% 23%

Find out:
i. degree of operating leverage, and
ii. degree of combined leverage for all the firms.

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Answer :

Calculation of Degree of Operating leverage and Degree of Combined leverage

Firm Degree of Operating Leverage (DOL) Degree of Combined Leverage (DCL)
% change inOperating Income % change inEPS
= =
% change inRevenue %change inRevenue
P 25% 30%
 0.926  1.111
27% 27%
Q 32% 24%
= 1.280 = 0.960
25% 25%
R 36% 21%
= 1.565 = 0.913
23% 23%
S 40% 23%
= 1.905 = 1.095
21% 21%

Question 30

The capital structure of ABC Ltd. as at 31.3.15 consisted of ordinary share capital of `
5,00,000 (face value ` 100 each) and 10% debentures of ` 5,00,000 (` 100 each). In the year
ended with March 15, sales decreased from 60,000 units to 50,000 units. During this year
and in the previous year, the selling price was ` 12 per unit; variable cost stood at ` 8 per
unit and fixed expenses were at ` 1,00,000 p.a. The income tax rate was 30%.

You are required to calculate the following:

i. The percentage of decrease in earnings per share.
ii. The degree of operating leverage at 60,000 units and 50,000 units.
iii. The degree of financial leverage at 60,000 units and 50,000 units.

Answer :

Sales in units 60,000 50,000

(`) (`)
Sales Value 7,30,000 6,00,000
Variable Cost (4,80,000) (4,00,000)
Contribution 2,40,000 2,00,000
Fixed expenses (1,00,000) (1,00,000)

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EBIT 1,40,000 1,00,000

Debenture Interest (50,000) (50,000)
EBT 90,000 50,000
Tax @ 30% (27,000) (15,000)
Profit after tax (PAT) 63,000 35,000

63,000 35,000
i. Earnings per share (EPS) = = ` 12.6 `7
5,000 5,000
Decrease in EPS = 12.6 – 7 = 5.6

Contribution ` 2,40,000 ` 2,00,000

ii. Operating Leverage =  1.71 2
EBIT ` 1,40,000 ` 1,00,000
EBIT ` 1,40,000 1,00,000
iii. Financial Leverage =  1.56 2
EBT ` 90,000 50,000

Question 31

From the following details of X Ltd., prepare the Income Statement for the year
ended 31st December, 2014:
Financial Leverage 2
Interest `2,000
Operating Leverage 3
Variable cost as a percentage of sales 75%
Income tax rate 30%

Answer :

Workings:
EBIT EBIT
i. Financial Leverage = Or, 2 
EBIT - Interest EBIT - ` 2,000
Or, EBIT = ` 4,000

Contribution Contribution
ii. Operating Leverage  Or, 3 
EBIT ` 4,000
Or, Contribution = ` 12,000

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Contribution ` 12,000
iii. Sales =   ` 48,000
P / V Ratio 25%

iv. Fixed Cost = Contribution – Fixed cost = EBIT

= `12,000 – Fixed cost = `4,000 Or, Fixed cost = ` 8,000

Income Statement for the year ended 31st December 2014

Particulars Amount (`)
Sales 48,000
Less: Variable Cost (75% of ` 48,000) (36,000)
Contribution 12,000
Less: Fixed Cost (Contribution - EBIT) (8,000)
Earnings Before Interest and Tax (EBIT) 4,000
Less: Interest (2,000)
Earnings Before Tax (EBT) 2,000
Less: Income Tax @ 30% (600)
Earnings After Tax (EAT or PAT) 1,400

Question 32

A firm has sales of ` 75,00,000 variable cost is 56% and fixed cost is ` 6,00,000. It has a debt
of ` 45,00,000 at 9% and equity of ` 55,00,000.
i. What is the firm’s ROI?
ii. Does it have favourable financial leverage?
iii. If the firm belongs to an industry whose capital turnover is 3, does it have a high or low
capital turnover?
iv. What are the operating, financial and combined leverages of the firm?
v. If the sales is increased by 10% by what percentage EBIT will increase?
vi. At what level of sales the EBT of the firm will be equal to zero?
vii. If EBIT increases by 20%, by what percentage EBT will increase?

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Answer :

Income Statement
Particulars Amount (`)
Sales 75,00,000
Less: Variable cost (56% of 75,00,000) 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
Earnings before interest and tax (EBIT) 27,00,000
Less: Interest on debt (@ 9% on ` 45 lakhs) 4,05,000
Earnings before tax (EBT) 22,95,000

EBIT EBIT
i. ROI   100   100
Capital employed Equity + Debt

(ROI is calculated on Capital Employed)

ii. ROI = 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.

Net Sales
iii. Capital Turnover=
Capital

Which is very low as compared to industry average of 3.

iv. Calculation of Operating, Financial and Combined leverages

Contribution
a. Operating Leverage 
EBIT

EBIT
b. Financial Leverage 
EBT

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Contribution
c. Combined Leverage 
EBT

Or = Operating Leverage × Financial Leverage = 1.22 × 1.18 = 1.44 (approx)

v. Operating leverage is 1.22. So if sales is increased by 10%.

EBIT will be increased by 1.22 × 10 i.e. 12.20% (approx)

vi. Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e. 69.44% to bring
EBT to Zero
Accordingly, New Sales = ` 75,00,000 × (1 - 0.6944)
= ` 75,00,000 × 0.3056
= ` 22,92,000 (approx)
Hence at ` 22,92,000 sales level EBT of the firm will be equal to Zero.

[Link] leverage is 1.18. So, if EBIT increases by 20% then EBT will increase by
1.18 × 20 = 23.6% (approx)

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 OTHER PROBLEMS

Question 1

From the following, prepare Income Statement of Company A and B.

Company A B
Financial leverage 3:1 4:1
Interest Rs.20,000 Rs.30,000
Operating leverage 4:1 5:1
Variable Cost as a Percentage to Sales 2 75%
66 %
3
Income tax Rate 45% 45%
Source : ICAI, MTP I (New)
Answer :

Working Notes:

Company A
EBIT 3
Financial leverage=  = Or, EBIT = 3× EBT ..............................(1)
EBT 1
Again EBIT – Interest = EBT
Or, EBIT- 20,000 = EBT .....................................................................(2)
Taking (1) and (2) we get
3 EBT- 20,000 = EBT
Or, 2 EBT = 20,000 or EBT = Rs.10,000
Hence EBIT = 3EBT = Rs.30,000
Contribution 4
Again, we have operating leverage = 
EBIT 1
EBIT = Rs. 30,000, hence we get
Contribution = 4 × EBIT = Rs.1,20,000
2
Now variable cost = 66 % on sales
3
2 1
Contribution = 100  66 % i.e. 33 % on sales
3 3
1, 20, 000
Hence, sales =  Rs. 3,60,000
1
33 %
3

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Same way EBIT, EBT, contribution and sales for company B can be worked out.

Company B
EBIT 4
Financial leverage =  or EBIT = 4 EBT ...............................(3)
EBT 1
Again EBIT – Interest = EBT or EBIT – 30,000 = EBT .....................(4)
Taking (3) and (4) we get, 4EBT- 30,000 = EBT
Or, 3EBT = 30,000 Or, EBT=10,000
Hence, EBIT = 4 × EBT= 40,000
Contribution 5
Again, we have operating leverage = 
EBIT 1
EBIT= 40,000; Hence we get contribution = 5 × EBIT = 2,00,000
Now variable cost =75% on sales
Contribution = 100- 75% i.e. 25% on sales
2,00,000
Hence Sales =  Rs. 8,00,000
25%

Income Statement
Company A B
Sales 3,60,000 8,00,000
Less: Variable Cost 2,40,000 6,00,000
Contribution 1,20,000 2,00,000
Less: Fixed Cost (bal. Fig) 90,000 1,60,000
EBIT 30,000 40,000
Less: Interest 20,000 30,000
EBT 10,000 10,000
Less: Tax 45% 4,500 4,500
EAT 5,500 5,500

Question 2

NSG Ltd. has a sale of ` 75,00,000, variable cost of ` 42,00,000 and fixed cost of ` 6,00,000.
The Present capital structure of NSG is as follows:
Equity Shares ` 55,00,000
Debt (12%) ` 45,00,000
Total ` 1,00,00,000

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i. Determine the ROCE of NSG Ltd.

ii. Does NSG have a favourable financial leverage? Analyse.
iii. If the industry average of asset turnover is 3, does it have a high or low asset
leverage? Determine
iv. Compute the leverages of NSG?
v. Determine, at what level of sales, will the EBT be zero?
Source : ICAI, MTP II (New)
Answer :

EBIT ` 27,00,000
i. ROCE =   100  27%
Captial employed ` 1,00,00,000

Workings:

Calculation of EBT: `
Sales 75,00,000
Less: Variable costs 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: Interest (12 % of Rs. 45,00,000) 5,40,000
EBT 21,60,000

Capital employed = Debt + Equity Shares = Rs. 1,00,00,000.

ii. Since ROCE (27%) is higher than the interest payable on debt (12%). NSG has a
favourable financial leverage.

iii. Capital employed = Total assets = Rs. 1,00,00,000

Net sales = Rs.75,00,000
`75,00,000
Therefore, turnover ratio = = 0.75
` 1,00,00,000
The industry average is 3 against NSG’s ratio of 0.75. Hence NSG Ltd. has very low
asset leverage.

Contribution 33,00,000
iv. Operating leverage =   1.22
EBIT 33,00,000
EBIT ` 27,00,000
Financial Leverage    1.25
EBT ` 21,60,000

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Contribution ` 33,00,000
Combined leverage   = 1.53
EBT ` 21,60,000
OR
DCL = DOL × DFL = 1.22 × 1.25 = 1.53

v. For EBT to become zero, a 100% reduction in the EBT is required. As the combined
leverage is 1.53, sales have to drop approx. by 100/1.53 = 65.36%. Hence, the new sales
will be:
` 75,00,000 × (1 – 0.6536) = Rs. 25,98,000 (approx.)

Question 3

The following data have been extracted from the books of LM Ltd:
Sales `100 lakhs
Interest Payable per annum ` 10 lakhs
Operating leverage 1.2
Combined leverage 2.16

You are required to calculate:

i. The financial leverage,
ii. Fixed cost and
iii. P/V ratio
Source : ICAI, May 2018 Question Paper
Answer :

i. Calculation of Financial Leverage:

Combined Leverage (CL) = Operating Leverage (OL)  Financial Leverage (FL)
2.16 = 1.2  FL
FL = 1.8

ii. Calculation of Fixed cost:

EBIT
1.8 
EBIT - 10,00,000
1.8 (EBIT – 10,00,000) = EBIT
1.8 EBIT - 18,00,000 = EBIT

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Contribution
Further, Operating Leverage =
EBIT
Contribution
1.2 =
` 22,50,000
Contribution = ` 27,00,000

Fixed Cost = Contribution – EBIT

= ` 27, 00,000 – ` 22,50,000
Fixed cost = ` 4,50,000

iii. Calculation of P/V ratio:

Question 4

Sohna Limited’s sales, variable costs and fixed cost amount to ` 75,00,000, ` 42,00,000 and
` 6,00,000 respectively. It has borrowed ` 45,00,000 at 9 per cent and its equity
capital totals ` 55,00,000.
a. What is Sohna Limited’s ROI?
b. Does it have favourable financial leverage?
c. If Sohna Limited belongs to an industry whose asset turnover is 3, does it have
a high or low asset leverage?
d. What are the operating, financial and combined leverages of Sohna Limited?
e. If the sales drops to ` 50,00,000, what will the new EBIT be?
Source : ICAI, RTP May 2015 (Old)
Answer :

a. Computation of Sohna Limited’s ROI

EBIT = Sales – Variable Cost – Fixed Cost

= ` 75 lakhs – ` 42 lakhs – ` 6 lakhs = ` 27 lakhs.

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b. Yes, Sohna Limited has favourable financial leverage as its ROI is higher than the
interest on debt.

c. Computation of Asset Turnover of Sohna Limited

The asset turnover of Sohna Limited is lower than the industry average of 3.

d. Computation of Leverages

EBIT ` 27 lakhs
Financial leverage =  = 1.18
EBIT- Interest ( ` 27 lakhs - ` 4.05 lakhs)
Sales - Variable cost ` 33 lakhs
Combined leverage =   1.44
EBIT - Interest ` 22,95,000

e. EBIT at Sales Level of ` 50 lakhs

`
Sales Revenue 50,00,000
Less: Variable Costs (50 lakhs × 0.56) 28,00,000
Less: Fixed Costs 6,00,000
EBIT 16,00,000

Question 5

The capital structure of the Shiva Ltd. consists of equity share capital of ` 10,00,000
(shares of ` 100 per value) and ` 10,00,000 of 10% Debentures, sales increased by 20% from
1,00,000 units to 1,20,000 units, the selling price is `10 per unit: variable costs
amount to ` 6 per unit and fixed expenses amount to `2,00,000. The income-tax rate is
assumed to be 50%.
a. You are required to calculate the following:
i. The percentage increase in earnings per share;
ii. Financial leverage at 1,00,000 units and 1,20,000 units.
iii. Operating leverage at 1,00,000 units and 1,20,000 units.
b. Comment on the behaviour of Operating and Financial leverages in relation to
increase in production from 1,00,000 units to 1,20,000 units.
Source : ICAI, RTP November 2016 (Old)
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Answer :

a. Comparative Statement of EPS, Financial & Operating Leverage

Particulars 1,00,000 units 1,20,000 units
(`) (`)
Sales at ` 10 per unit 10,00,000 12,00,000
Less: Variable costs at ` 6 per unit 6,00,000 7,20,000
Contribution (C) at ` 4 per unit 4,00,000 4,80,000
Less: Fixed expenses 2,00,000 2,00,000
Operating Profit or EBIT 2,00,000 2,80,000
Less Interest on Debentures (10% on ` 10 Lakhs) 1,00,000 1,00,000
Profit before tax (PBT) 1,00,000 1,80,000
Less Tax at 50% 50,000 90,000
Profit after tax (PAT) or net profit 50,000 90,000
(i) Earnings per Share (EPS) [10,000 equity shares] 50,000 90,000
` 5 ` 9
10,000 10,000
% increase in EPS

 EBIT  2,00,000 2,80,000

(ii) Financial leverage   2  1.56
 PBT  1,00,000 1,80,000

 Contribution  4,00,000 4,80,000

(iii) Operating leverage   2  1.714
 EBIT  2,00,000 2, 80, 000

b. In relation to increase in Production & Sales of 1,00,000 units to 1,20,000 units

(20% increase), EPS has gone from ` 5 to ` 9 i.e. increased by 80%. But both the Financial
Leverage and Operating Leverage have decreased with increase in sales. Due to this
reduction, both the risks i.e. business risk & financial risks of the business are
reduced.

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 THEORETICAL QUESTIONS

Source : ICAI, Compilation (Old) - (From Question No. 1 - 4 )

Question 1

Discuss the impact of financial leverage on shareholders wealth by using return-

on-assets (ROA) and return-on-equity (ROE) analytic framework.

Answer :

The impact of financial leverage on ROE is positive, if cost of debt (after-tax) is less
than ROA. But it is a double-edged sword.

D
ROE = ROA + (ROA - K d )
E
Where
NOPAT = EBIT * ( 1 - Tc)
Capital employed = Shareholders funds + Loan funds
D = Debt amount in capital structure
E = Equity capital amount in capital structure
Kd = Interest rate * ( 1 - Tc) in case of fresh loans of a company.
Kd = Yield to maturity *(1 - Tc) in case of existing loans of a company.

Question 2

Differentiate between Business risk and Financial risk.

Answer :

Business Risk and Financial Risk

Business risk refers to the risk associated with the firm’s operations. It is an unavoidable
risk because of the environment in which the firm has to operate and the business
risk is represented by the variability of earnings before interest and tax (EBIT). The
variability in turn is influenced by revenues and expenses. Revenues and expenses are
affected by demand of firm’s products, variations in prices and proportion of fixed cost in
total cost.

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Whereas, Financial risk refers to the additional risk placed on firm’s shareholders as a result
of debt use in financing. Companies that issue more debt instruments would have
higher financial risk than companies financed mostly by equity. Financial risk can
be measured by ratios such as firm’s financial leverage multiplier, total debt to assets ratio
etc.

Question 3

Explain the concept of leveraged lease.

Answer :

Concept of Leveraged Lease: Leveraged lease involves lessor, lessee and financier. In
leveraged lease, the lessor makes a substantial borrowing, even upto 80 per cent of
the assets purchase price. He provides remaining amount – about 20 per cent or so – as
equity to become the owner. The lessor claims all tax benefits related to the ownership of
the assets. Lenders, generally large financial institutions, provide loans on a non-
recourse basis to the lessor. Their debt is served exclusively out of the lease proceeds. To
secure the loan provided by the lenders, the lessor also agrees to give them a mortgage on
the asset. Leveraged lease are called so because the high non-recourse debt creates a high
degree of leverage.

Question 4

“Operating risk is associated with cost structure, whereas financial risk is

associated with capital structure of a business concern.” Critically examine this
statement.

Answer :

“Operating risk is associated with cost structure whereas financial risk is associated
with capital structure of a business concern”.

Operating risk refers to the risk associated with the firm’s operations. It is represented by
the variability of earnings before interest and tax (EBIT). The variability in turn is
influenced by revenues and expenses, which are affected by demand of firm’s products,
variations in prices and proportion of fixed cost in total cost. If there is no fixed cost, there
would be no operating risk. Whereas financial risk refers to the additional risk placed
on firm’s shareholders as a result of debt and preference shares used in the capital
structure of the concern. Companies that issue more debt instruments would have
higher financial risk than companies financed mostly by equity.

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Question 5

If a company’s profits are more sensitive to changes in sales volume, then what
would be effect on the company’s operating leverage?
Source : ICAI, RTP November 2013 (Old)
Answer :

If a company’s profits are more sensitive to changes in sales volume, then the
contribution will increase, with a resultant increase in the company’s operating
leverage.
Contribution
Operating Leverage 
EBIT

Question 6

Differentiate between Financial lease and Operating lease.

Source : ICAI, RTP November 2014 (Old)
Answer :

Difference between Financial Lease and Operating Lease

Financial Lease Operating Lease
1. The risk and reward incident to 1. The lessee is only provided the use of
ownership are passed on the lessee. the asset for a certain time. Risk
The lessor only remains the legal incident to ownership belongs only
owner of the asset. to the lessor.
2. The lessee bears the risk of 2. The lessee is only allowed the use of
obsolescence. asset.
3. The lease is non-cancellable by either 3. The lease is kept cancellable by the
party under it. lessor.
4. The lessor does not bear the cost of 4. Usually, the lessor bears the cost of
repairs, maintenance or operations. repairs, maintenance or operations.
5. The lease is usually full payout. 5. The lease is usually non-payout.

Question 7

“Financial Leverage is a double edged sword” Comment.

Source : ICAI, RTP November 2015 (Old)

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Answer :

On one hand when cost of ‘fixed cost fund’ is less than the return on investment
financial leverage will help to increase return on equity and EPS. The firm will also benefit
from the saving of tax on interest on debts etc. However, when cost of debt will be more
than the return it will affect return of equity and EPS unfavourably and as a result firm
can be under financial distress. This is why financial leverage is known as “double
edged sword”.

Effect on EPS and ROE:

When Effect Result

ROI > Interest Favourable Advantage
ROI < Interest Unfavourable Disadvantage
ROI = Interest Neutral Neither advantage nor
disadvantage

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Chapter
INVESTMENT DECISIONS
7

LEARNING OUTCOMES
 State the objectives of capital investment decisions.
 Discuss the importance and purpose of Capital budgeting for a business entity.
 Calculate cash flows in capital budgeting decisions and try to explain the basic
principles for measuring the same.
 Discuss the various investment evaluation techniques like Pay- back, Net Present
Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), Modified Internal
Rate of Return (MIRR) and Accounting Rate of Return (ARR).
 Apply the concepts of the various investment evaluation techniques for capital
investment decision making.
 Discuss the advantages and disadvantages of the above- mentioned techniques.

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CHAPTER OVERVIEW

INVESTMENT DECISION

Types of Investment Capital Budgeting

Decision Techniques :
 Pay back period
 Accounting Rate of Return
Basic Principles for (ARR)
measuring Project  Net Present Value (NPV)
Cash Flow  Profitability Index (PI)
 Internal Rate of Return
(IRR)
Capital budgeting in  Modified Internal Rate of
special cases Return (MIRR)
 Discounted Pay Back
period

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SUMMARY

 Capital budgeting is the process of evaluating and selecting long-term investments

that are in line with the goal of investor’s wealth maximization.
 The capital budgeting decisions are important, crucial and critical business
decisions due to substantial expenditure involved; long period for the recovery
of benefits; irreversibility of decisions and the complexity involved in capital
investment decisions.
 One of the most important tasks in capital budgeting is estimating future cash
flows for a project. The final decision we make at the end of the capital budgeting
process is no better than the accuracy of our cash-flow estimates.
 Tax payments like other payments must be properly deducted in deriving the cash
flows. That is, cash flows must be defined in post-tax terms.
 There are a number of capital budgeting techniques available for appraisal of
investment proposals and can be classified as traditional (non-discounted) and
time-adjusted (discounted).
 The most common traditional capital budgeting techniques are Payback Period
and Accounting (Book) Rate of Return.
Total initial capital investment
Payback period =
Annual expected after - tax net cash flow
Average annual cash inflow
Payback Reciprocal =
Initial investment
 The most common time-adjusted capital budgeting techniques are Net Present
Value Technique and Internal Rate of Return Method.

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. A capital budgeting technique which does not require the computation of cost of
capital for decision making purposes is,
a. Net Present Value method
b. Internal Rate of Return method
c. Modified Internal Rate of Return method
d. Pay back

2. If two alternative proposals are such that the acceptance of one shall exclude the
possibility of the acceptance of another then such decision making will lead to,
a. Mutually exclusive decisions
b. Accept reject decisions
c. Contingent decisions
d. None of the above

3. In case a company considers a discounting factor higher than the cost of capital for
arriving at present values, the present values of cash inflows will be
a. Less than those computed on the basis of cost of capital
b. More than those computed on the basis of cost of capital
c. Equal to those computed on the basis of the cost of capital
d. None of the above

4. The pay back technique is specially useful during times

a. When the value of money is turbulent
b. When there is no inflation
c. When the economy is growing at a steady rate coupled with minimal inflation.
d. None of the above

5. While evaluating capital investment proposals, time value of money is used in

which of the following techniques,
a. Payback method
b. Accounting rate of return
c. Net present value
d. None of the above

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6. IRR would favour project proposals which have,

a. Heavy cash inflows in the early stages of the project.
b. Evenly distributed cash inflows throughout the project
c. Heavy cash inflows at the later stages of the project
d. None of the above.

7. The re- investment assumption in the case of the IRR technique assumes that,
a. Cash flows can be re- invested at the projects IRR
b. Cash flows can be re- invested at the weighted cost of capital
c. Cash flows can be re- invested at the marginal cost of capital
d. None of the above

8. Multiple IRRs are obtained when,

a. Cash flows in the early stages of the project exceed cash flows during the later
stages.
b. Cash flows reverse their signs during the project
c. Cash flows are un even
d. None of the above.

9. Depreciation is included as a cost in which of the following techniques,

a. Accounting rate of return
b. Net present value
c. Internal rate of return
d. None of the above

10. Management is considering a ` 1,00,000 investment in a project with a 5 year life and
no residual value . If the total income from the project is expected to be ` 60,000 and
recognition is given to the effect of straight line depreciation on the investment, the
average rate of return is :
a. 12%
b. 24%
c. 60%
d. 75%

11. Assume cash outflow equals ` 1,20,000 followed by cash inflows of ` 25,000 per year
for 8 years and a cost of capital of 11%. What is the Net present value?
a. (` 38,214)
b. ` 9,653
c. ` 8,653
d. ` 38,214
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12. What is the Internal rate of return for a project having cash flows of ` 40,000 per year
for 10 years and a cost of ` 2,26,009?
a. 8%
b. 9%
c. 10%
d. 12%

13. While evaluating investments, the release of working capital at the end of the
projects life should be considered as,
a. Cash in flow
b. Cash out flow
c. Having no effect upon the capital budgeting decision
d. None of the above.

14. Capital rationing refers to a situation where,

a. Funds are restricted and the management has to choose from amongst
available alternative investments.
b. Funds are unlimited and the management has to decide how to allocate them to
suitable projects.
c. Very few feasible investment proposals are available with the management.
d. None of the above

15. Capital budgeting is done for

a. Evaluating short term investment decisions.
b. Evaluating medium term investment decisions.
c. Evaluating long term investment decisions.
d. None of the above

ANSWERS

1. d 2. a

3. a 4. a
5. c 6. a
7. a 8. b
9. a 10. b
11. c 12. d
13. a 14. a
15. c

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 ILLUSTRATIONS

Source : ICAI, SM (New) - (From Question No. 1 - 16 )

Question 1

ABC Ltd is evaluating the purchase of a new project with a depreciable base of
`1,00,000; expected economic life of 4 years and change in earnings before taxes and
depreciation of `45,000 in year 1, `30,000 in year 2, `25,000 in year 3 and `35,000 in
year 4. Assume straight-line depreciation and a 20% tax rate. You are required to
compute relevant cash flows.

Answer :
Amount (in `)
Years
1 2 3 4
Earnings before tax and depreciation 45,000 30,000 25,000 35,000
Less: Depreciation (25,000) (25,000) (25,000) (25,000)
Earnings before tax 20,000 5,000 0 10,000
Less: Tax @20% (4,000) (1,000) 0 (2,000)
16,000 4,000 0 8,000
Add: Depreciation 25,000 25,000 25,000 25,000
Net Cash flow 41,000 29,000 25,000 33,000

Working Note :
Depreciation = `1, 00,000 ÷ 4 = `25,000

Question 2

A project requiring an investment of `10,00,000 and it yields profit after tax and
depreciation which is as follows:
Years Profit after tax and depreciation (`)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000

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Suppose further that at the end of the 5th year, the plant and machinery of the project can
be sold for ` 80,000. Determine Average Rate of Return.

Answer :

In this case the rate of return can be calculated as follows:

TotalProfit  No. of years

100
Averageinvestment/Initialinvestment

a. If Initial Investment is considered then,

` 4, 60, 000  5 years ` 92, 000
  100   100  9.2%
` 10, 00, 000 ` 10, 00, 000
This rate is compared with the rate expected on other projects, had the same
funds been invested alternatively in those projects. Sometimes, the management
compares this rate with the minimum rate (called-cut off rate) they may have in mind.
For example, management may decide that they will not undertake any project
which has an average annual yield after tax less than 20%. Any capital
expenditure proposal which has an average annual yield of less than 20% will be
automatically rejected.

b. If Average investment is considered, then,

92 , 000 92 , 000
  100   100  17%
Averageinvestment 5, 40, 000

Where,
Average Investment = ½ (Initial investment – Salvage value) + Salvage value
= ½ (10,00,000 – 80,000) + 80,000
= 4,60,000 + 80,000 = 5,40,000

Question 3

Compute the net present value for a project with a net investment of ` 1, 00,000 and net
cash flows year one is ` 55,000; for year two is ` 80,000 and for year three is ` 15,000.
Further, the company’s cost of capital is 10%?
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]

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Answer :

Year Net Cash Flows PVIF @ 10% Discounted Cash Flows

0 (1,00,000) 1.000 (1,00,000)

1 55,000 0.909 49,995
2 80,000 0.826 66,080
3 15,000 0.751 11,265
Net Present Value 27,340

Recommendation : Since the net present value of the project is positive, the company
should accept the project.

Question 4

ABC Ltd is a small company that is currently analyzing capital expenditure proposals
for the purchase of equipment; the company uses the net present value technique to
evaluate projects. The capital budget is limited to ` 500,000 which ABC Ltd believes is the
maximum capital it can raise. The initial investment and projected net cash flows for each
project are shown below. The cost of capital of ABC Ltd is 12%. You are required to
compute the NPV of the different projects.

Project A Project B Project C Project D

Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000

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Answer :

Calculation of net present value:

Period PV factor Project A Project B Project C Project D

0 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000)
1 0.893 44,650 35,720 66,975 66,975
2 0.797 39,850 39,850 59,775 59,775
3 0.712 35,600 49,840 42,720 42,720
4 0.636 31,800 47,700 50,880 25,440
5 0.567 28,350 42,525 56,700 11,340
Net Present Value (19,750) 25,635 27,050 (3,750)

Question 5

Suppose we have three projects involving discounted cash outflow of ` 5,50,000, ` 75,000
and ` 1,00,20,000 respectively. Suppose further that the sum of discounted cash inflows for
these projects are ` 6,50,000, ` 95,000 and ` 1,00,30,000 respectively. Calculate the
desirability factors for the three projects.

Answer :

The desirability factors for the three projects would be as follows:

It would be seen that in absolute terms project 3 gives the highest cash inflows yet its
desirability factor is low. This is because the outflow is also very high. The Desirability/
Profitability Index factor helps us in ranking various projects.
Since PI is an extension of NPV it has same advantages and limitation.

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Question 6

A Ltd. is evaluating a project involving an outlay of ` 10,00,000 resulting in an annual cash

inflow of ` 2,50,000 for 6 years. Assuming salvage value of the project is zero
determine the IRR of the project.

Answer :

First of all we shall find an approximation of the payback period:

1, 00, 000
4
26, 000
Now we shall this figure in the PVAF table corresponding to 6-year row.
The value 4 lies between values 4.111 and 3.998 correspondingly discounting rates
12% and 13% respectively.
NPV @ 12%
NPV12% = (1,00,000) + 4.111 × 25,000 = 2,775
NPV13% = = (1,00,000) + 3.998 × 25,000 = (50)
The internal rate of return is, thus, more than 12% but less than 13%. The exact rate can be
obtained by interpolation:

Scenario 2: When the net cash flows are not uniform over the life of the investment, the
determination of the discount rate can involve trial and error and interpolation
between discounting rates as mentioned above. However, IRR can also be found out by
using following procedure:
Step 1: Discount the cash flow at any random rate say 10%, 15% or 20% randomly.
Step 2: If resultant NPV is negative then discount cash flows again by lower discounting
rate to make NPV positive. Conversely, if resultant NPV is positive then again discount
cash flows by higher discounting rate to make NPV negative.
Step 3: Use following Interpolation Formula:

Where
LR = Lower Rate
HR = Higher Rate

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Question 7

Calculate the internal rate of return of an investment of `1,36,000 which yields the
following cash inflows:

Year Cash Inflows (in `)

1 30,000
2 40,000
3 60,000
4 30,000
5 20,000

Answer :

Let us discount cash flows by 10%.

Year Cash Inflows (`) Discounting factor at 10% Present Value (`)

1 30,000 0.909 27,270

2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490
5 20,000 0.621 12,420
Total present value 1,38,280

The present value at 10% comes to `1,38,280, which is more than the initial investment.
Therefore, a higher discount rate is suggested, say, 12%.

Year Cash Inflows (`) Discounting factor at 12% Present Value (`)

1 30,000 0.893 26,790

2 40,000 0.797 31,880
3 60,000 0.712 42,720
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Total present value 1,31,810

The internal rate of return is, thus, more than 10% but less than 12%. The exact rate can be
obtained by interpolation:
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Question 8

A company proposes to install machine involving a capital cost of ` 3,60,000. The life of the
machine is 5 years and its salvage value at the end of the life is nil. The machine will
produce the net operating income after depreciation of ` 68,000 per annum. The company’s
tax rate is 45%.
The Net Present Value factors for 5 years are as under:

Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13

You are required to calculate the internal rate of return of the proposal.

Answer :

Computation of Cash inflow per annum (`)

Net operating income per annum 68,000

Less: Tax @ 45% 30,600
Profit after tax 37,400
Add: Depreciation(`3,60,000 / 5 years) 72,000
Cash inflow 1,09,400

The IRR of the investment can be found as follows:

NPV = −`3,60,000 + `1,09,400 (PVAF5, r) = 0
` 3, 60, 000
or PVA F5 , r  Cumulative factor    3.29
` 1, 09, 400

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Computation of Internal Rate of Return

Discounting Rate 15% 16%

Cumulative factor 3.35 3.27
PV of Inflows 3,66,490 3,57,738
(`1,09,400 × 3.35) (`1,09,400 × 3.27)
Initial outlay (`) 3,60,000 3,60,000
NPV (`) 6,490 (2,262)

 6 , 490 
IRR  15     15  0.74  15.74%
 6 , 490  2 , 262 

Question 9

An investment of ` 1,36,000 yields the following cash inflows (profits before depreciation
but after tax). Determine MIRR considering 8% as cost of capital.

Year `
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000

Answer :

Year- 0 , Cash flow- `1,36,000

The MIRR is calculated on the basis of investing the inflows at the cost of capital. The table
below shows the valued of the inflows if they are immediately reinvested at 8%.

Year Cash flow @ 8% reinvestment rate factor `

1 30,000 1.3605* 40,815
2 40,000 1.2597 50,388
3 60,000 1.1664 69,984
4 30,000 1.0800 32,400
5 20,000 1.0000 20,000
2,13,587

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* Investment of ` 1 at the end of the year 1 is reinvested for 4 years (at the end of 5 years) shall
become 1(1.08)4= 1.3605. Similarly, reinvestment rate factor for remaining years shall be
calculated. Please note investment at the end of 5th year shall be reinvested for zero year
hence reinvestment rate factor shall be 1.00.

The total cash outflow in year 0 (` 1,36,000) is compared with the possible inflow at year 5
1, 36 , 000
and the resulting figure of  0.6367 is the discount factor in year 5. By looking at
2 ,13, 587
the year 5 row in the present value tables, you will see that this gives a return of 9%. This
means that the ` 2,13,587 received in year 5 is equivalent to ` 1,36,000 in year 0 if the
discount rate is 9%. Alternatively, we can compute MIRR as follows:
2 ,13, 587
Total return   1.5705
1, 36 , 000
MIRR 1 / 5 1.5705  1  9%

Question 10

Suppose there are two Project A and Project B are under consideration. The cash flows
associated with these projects are as follows:

Year Project A Project B

0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000

Assuming Cost of Capital equal to 10% which project should be accepted as per NPV
Method and IRR Method.

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Answer :

Net Present Value of Projects

Cash Inflows Cash Inflows Present Value PV of PV of

Year
Project A (`) Project B (`) Factor @ 10% Project A (`) Project B (`)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.909 45,450 1,27,260
2 60,000 1,90,000 0.826 49,560 1,56,940
3 40,000 1,00,000 0.751 30,040 75,100
25,050 59,300

Internal Rate of Returns of projects

Since by discounting cash flows at 10% we are getting values very far from zero. Therefore,
let us discount cash flows using 20% discounting rate.

Year Cash Inflows Cash Inflows Present Value PV of PV of

Project A (`) Project B (`) Factor @ 20% Project A (`) Project B (`)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.833 41,650 1,16,620
2 60,000 1,90,000 0.694 41,640 1,31,860
3 40,000 1,00,000 0.579 23,160 57,900
6,450 6,380

Since by discounting cash flows at 20% we are getting values far from zero.
Therefore, let us discount cash flows using 25% discounting rate.

Year Cash Inflows Cash Inflows Present Value PV of Project PV of

Project A (`) Project B (`) Factor @ 25% A (`) Project B (`)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.800 40,000 1,12,000
2 60,000 1,90,000 0.640 38,400 1,21,600
3 40,000 1,00,000 0.512 20,480 51,200
(1,120) (15,200)

The internal rate of return is, thus, more than 20% but less than 25%. The exact rate can be
obtained by interpolation:

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Overall Position

Project A Project B
NPV @ 10% 25,050 59,300
IRR 24.26% 21.48%

Thus there is contradiction in ranking by two methods.

Scenario 2 – Time Disparity in Cash Flows

It might be possible that overall cash flows may be more or less same in the projects but
there may be disparity in their flows i.e. larger part of cash inflows may be occurred in the
beginning or end of the project. In such situation there may be difference in the ranking of
projects as per two methods.

Question 11

Suppose ABC Ltd. is considering two Project X and Project Y for investment. The cash
flows associated with these projects are as follows :

Year Project X Project Y

0 (2,50,000) (3,00,000)
1 2,00,000 50,000
2 1,00,000 1,00,000
3 50,000 3,00,000

Assuming Cost of Capital be 10%, which project should be accepted as per NPV Method
and IRR Method.

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CA INTER FINANCIAL MANAGEMENT

Answer :

Net Present Value of Projects

Year Cash Inflows CashInflows Present Value PV of PV of

Project X (`) Project Y (`) Factor @ 10% Project X (`) Project Y (`)
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.909 1,81,800 45,450
2 1,00,000 1,00,000 0.826 82,600 82,600
3 50,000 3,00,000 0.751 37,550 2,25,300
51,950 53,350

Internal Rate of Returns of projects

Since by discounting cash flows at 10% we are getting values far from zero.
Therefore, let us discount cash flows using 20% discounting rate.

Year Cash Inflows Cash Inflows Present Value PV of PV of

Project X (`) Project Y (`) Factor @ 20% Project X (`) Project Y (`)
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.833 1,66,600 41,650
2 1,00,000 1,00,000 0.694 69,400 69,400
3 50,000 3,00,000 0.579 28,950 1,73,700
14,950 (15,250)

Since by discounting cash flows at 20% we are getting value of Project X is positive and
value of Project Y is negative. Therefore, let us discount cash flows of Project X using 25%
discounting rate and Project Y using discount rate of 1

Year Cash Inflows Present Value PV of Cash Inflows Present PV of

Project X (`) Factor @ 25% Project X (`) Project Y (`) Value Project Y
Factor @ (`)
15%
0 (2,50,000) 1.000 (2,50,000) (3,00,000) 1.000 (3,00,000)
1 2,00,000 0.800 1,60,000 50,000 0.870 43,500
2 1,00,000 0.640 64,000 1,00,000 0.756 75,600
3 50,000 0.512 25,600 3,00,000 0.658 1,97,400
(400) 16,500

The internal rate can be obtained by interpolation:

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Overall Position

Project A Project B
NPV @ 10% 51,950 53,350
IRR 24.87% 17.60%

Thus there is contradiction in ranking by two methods.

Scenario 3 – Disparity in life of Proposals (Unequal Lives)

Conflict in ranking may also arise if we are comparing two projects (especially mutually
exclusive) having unequal lives.

Question 12

Suppose MVA Ltd. is considering two Project A and Project B for investment. The cash
flows associated with these projects are as follows:

Year Project A Project B

0 (5,00,000) (5,00,000)
1 7,50,000 2,00,000
2 2,00,000
3 7,00,000

Assuming Cost of Capital equal to 12%, which project should be accepted as per NPV
Method and IRR Method?

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CA INTER FINANCIAL MANAGEMENT

Answer :

Net Present Value of Projects

Year Cash Inflows Cash Inflows Present Value PV of PV of

Project A (`) Project B (`) Factor @ 12% Project A (`) Project B (`)

0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)

1 7,50,000 2,00,000 0.893 6,69,750 1,78,600
2 2,00,000 0.797 1,59,400
3 7,00,000 0.712 4,98,400
1,69,750 3,36,400

Internal Rate of Returns of projects

Let us discount cash flows using 50% discounting rate.

Year Cash Inflows Cash Inflows Present Value PV of PV of

Project A Project B Factor @ 50% Project A Project B
(`) (`) (`) (`)
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)
1 7,50,000 2,00,000 0.667 5,00,025 1,33,400
2 2,00,000 0.444 88,800
3 7,00,000 0.296 2,07,200
25 (70,600)

Since, IRR of project A shall be 50% as NPV is almost near to zero. Further, by discounting cash
flows at 50% we are getting NPV of Project B negative, let us discount cash flows of Project
B using 15% discounting rate.

Year Cash Inflows Present Value PV of

Project B (`) Factor @ 15% Project B (`)

0 (5,00,000) 1.000 (5,00,000)

1 2,00,000 0.870 1,74,000
2 2,00,000 0.756 1,51,200
3 7,00,000 0.658 4,60,600
2,85,800

The internal rate can be obtained by interpolation:

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Overall Position
Project A Project B
NPV @ 10% 1,69,750 3,36,400
IRR 50.00% 43.07%

Thus there is contradiction in ranking by two methods.

Question 13

Shiva Limited is planning its capital investment programme for next year. It has five
projects all of which give a positive NPV at the company cut-off rate of 15 percent, the
investment outflows and present values being as follows:

Investment NPV @ 15%

Project
`000 `000
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3

The company is limited to a capital spending of `1,20,000.

You are required to optimise the returns from a package of projects within the capital
spending limit. The projects are independent of each other and are divisible (i.e., part-
project is possible).

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Answer :

Computation of NPVs per ` 1 of Investment and Ranking of the Projects

Project Investment NPV @ 15% NPV per `1 Ranking

` 000 ` 000 invested
A (50) 15.4 0.31 5
B (40) 18.7 0.47 2
C (25) 10.1 0.40 3
D (30) 11.2 0.37 4
E (35) 193 0.55 1

Building up of a Programme of Projects based on their Rankings

Investment NPV @ 15%
Project
`000 `000
E (35) 19.3
B (40) 18.7
C (25) 10.1
D (20) 7.5 (2/3 of project
total)
120 55.6

Thus Project A should be rejected and only two-third of Project D be undertaken. If the
projects are not divisible then other combinations can be examined as
Investment NPV @ 15%
` 000 `000
E+B+C 100 48.1
E+B+D 105 49.2

In this case E + B + D would be preferable as it provides a higher NPV despite D

ranking lower than C.

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Question 14

R plc is considering to modernize its production facilities and it has two proposals under
consideration. The expected cash flows associated with these projects and their NPV as per
discounting rate of 12% and IRR is as follows:

Year Cash Flow

Project A (`) Project B (`)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000
5 11,00,000
6 10,00,000
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%

Which project should R plc accept?

Answer :

Although from NPV point of view Project A appears to be better but from IRR point of
view Project B appears to be better. Since, both projects have unequal lives selection on the
basis of these two methods shall not be proper. In such situation we shall use any of the
following method:

(i) Replacement Chain (Common Life) Method: Since the life of the Project A is 6 years
and Project B is 3 years to equalize lives we can have second opportunity of investing
in project B after one time investing. The position of cash flows in such situation shall
be as follows:

NPV of extended life of 6 years of Project B shall be ` 8,82,403 and IRR of 25.20%.
Accordingly, with extended life NPV of Project B it appears to be more attractive.

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(ii) Equivalent Annualized Criterion : The method discussed above has one drawback
when we have to compare two projects one has a life of 3 years and other has 5 years.
In such case the above method shall require analysis of a period of 15 years i.e.
common multiple of these two values. The simple solution to this problem is use of
Equivalent Annualised Criterion involving following steps:
a. Compute NPV using the WACC or discounting rate.
b. Compute Present Value Annuity Factor (PVAF) of discounting factor used
above for the period of each project.
c. Divide NPV computed under step (a) by PVAF as computed under step (b) and
compare the values.
Accordingly, for proposal under consideration:

Project A Project B
NPV @ 12% ` 6,49,094 `5,15,488
PVAF @12% 4.112 2.402
Equivalent Annualized Criterion `1,57,854 `2,14,608

Thus, Project B should be selected.

Question 15

Alpha Company is considering the following investment projects :

Cash Flows (`)

Projects
C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000

a. Rank the projects according to each of the following methods: (i) Payback, (ii) ARR, (iii)
IRR and (iv) NPV, assuming discount rates of 10 and 30 per cent.
b. Assuming the projects are independent, which one should be accepted? If the projects
are mutually exclusive, which project is the best?

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Answer :

a.
i. Payback Period
Project A : 10,000/10,000 = 1 year
Project B: 10,000/7,500 = 1 1/3 years.
10 , 000  6 , 000 1
Pr oject C : 2 year   2 years
12 , 000 3
Project D: 1 year.

ii. ARR

Note: This net cash proceed includes recovery of investment also. Therefore, net cash
earnings are found by deducting initial investment.

iii. IRR

The net cash proceeds in year 1 are just equal to investment.

Project A:
Therefore, r = 0%.
This project produces an annuity of `7,500 for two years.
Project B: Therefore, the required PVAF is: 10,000/7,500 = 1.33.
This factor is found under 32% column. Therefore, r = 32%
Since cash flows are uneven, the trial and error method will be
followed. Using 20% rate of discount the NPV is + `1,389. At 30% rate
Project C: of discount, the NPV is -`633. The true rate of return should be less
than 30%. At 27% rate of discount it is found that the NPV is -`86 and
at 26% +`105. Through interpolation, we find r = 26.5%
In this case also by using the trial and error method, it is found that at
Project D: 37.6% rate of discount NPV becomes almost zero.
Therefore, r = 37.6%.

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iv. NPV
Project A :
at 10% -10,000 +10,000 × 0.909 = -910
at 30% -10,000 +10,000 × 0.769 = -2,310

Project B:
at 10% -10,000 + 7,500 (0.909 + 0.826) = 3,013
at 30% -10,000 + 7,500 (0.769 + 0.592) = +208

Project C:
at 10% -10,000 + 2,000 × 0.909 + 4,000 × 0.826 +12,000 × 0.751= + 4,134
at 30% -10,000 + 2,000 × 0.769 + 4,000 × 0.592 + 12,000 × 0.455 = - 633

Project D:
at 10% -10,000 +10,000 × 0.909 + 3,000 × (0.826 + 0.751) = + 3,821
at 30% -10,000 +10,000 × 0.769 + 3,000 × (0.592 + 0.455) = + 831

The projects are ranked as follows according to the various methods:

Ranks
Projects PBP ARR IRR NPV(10%) NPV(30%)

A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
D 1 3 1 2 1

b. Payback and ARR are theoretically unsound method for choosing between the
investment projects. Between the two time-adjusted (DCF) investment criteria, NPV and
IRR, NPV gives consistent results. If the projects are independent (and there is no capital
rationing), either IRR or NPV can be used since the same set of projects will be accepted
by any of the methods. In the present case, except Project A all the three projects should
be accepted if the discount rate is 10%. Only Projects B and D should be undertaken if
the discount rate is 30%.

If it is assumed that the projects are mutually exclusive, then under the assumption of 30%
discount rate, the choice is between B and D (A and C are unprofitable). Both criteria IRR
and NPV give the same results – D is the best. Under the assumption of 10% discount rate,
ranking according to IRR and NPV conflict (except for Project A). If the IRR rule is
followed, Project D should be accepted. But the NPV rule tells that Project C is the best. The
NPV rule generally gives consistent results in conformity with the wealth maximization
principle. Therefore, Project C should be accepted following the NPV rule.
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Question 16

The expected cash flows of three projects are given below. The cost of capital is 10 percent.
a. Calculate the payback period, net present value, internal rate of return and accounting
rate of return of each project.
b. Show the rankings of the projects by each of the four methods.

Period Project A (`) Project B (`) Project C (`)

0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100
6 900 1,200
7 900 1,300
8 900 1,400
9 900 1,500
10 900 1,600
Answer :

a. Payback Period Method

A = 5 + (500/900) = 5.56 years
B = 5 + (500/1,200) = 5.42 years
C = 2 + (1,000/2,000) = 2.5 years
Net Present Value
NPVA = (- 5,000) + (900 × 6.145) = (5,000) + 5,530.5 = `530.5
NPVB = is calculated as follows:
Year Cash flow (`) 10% discount factor Present value (`)

0 (5000) 1.000 (5,000)

1 700 0.909 636
2 800 0.826 661
3 900 0.751 676
4 1000 0.683 683
5 1100 0.621 683
6 1200 0.564 677
7 1300 0.513 667
8 1400 0.467 654
9 1500 0.424 636
10 1600 0.386 618
1591

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NPVC is calculated as follows:

Year Cash flow (`) 10% discount factor Present value (`)
0 (5000) 1.000 (5,000)
1 2000 0.909 1,818
2 2000 0.826 1,652
3 2000 0.751 1,502
4 1000 0.683 683
655

Internal Rate of Return

NPV at 12% = (5,000) + 900 × 5.650
= (5,000) + 5085 = 85
NPV at 13% = (5,000) + 900 × 5.426
= (5,000) + 4,883.40 = -116.60
 85 
IRRA  12    13  12  12  0.42
 85  116.60 
IRRA = 12.42%.

IRRB

Year Cash flow 10% Present value 20% Present

(`) discount factor (`) discount factor value (`)

0 (5,000) 1.000 (5,000) 1.000 (5,000)

1 700 0.909 636 0.833 583
2 800 0.826 661 0.694 555
3 900 0.751 676 0.579 521
4 1,000 0.683 683 0.482 482
5 1,100 0.621 683 0.402 442
6 1,200 0.564 677 0.335 402
7 1,300 0.513 667 0.279 363
8 1,400 0.467 654 0.233 326
9 1,500 0.424 636 0.194 291
10 1,600 0.386 618 0.162 259
1,591 (776)

1, 591
Interpolating : IIRB  10%    20%  10%  10%  6.72%  16.72%
1, 591  776

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IRRC

Year Cash flow 15% Present value 18% discount Present

(`) discount factor (`) factor value (`)
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 2,000 0.870 1,740 0.847 1,694
2 2,000 0.756 1,512 0.718 1,436
3 2,000 0.658 1,316 0.609 1,218
4 1,000 0.572 572 0.516 516
140 (136)

140
Interpolating : 1IIRC  15%   18%  15%  15%  1.52%  16.52%
140  136
Accounting Rate of Return
5 , 000
ARRA  Average capital employed  ` 2 , 500
2

Average accounting profit 

 9 , 000  5 , 000 ` 400
10

ARRA 
 400  100  16 per cent
2 , 500

ARRB : Average accounting profit 

11, 500  5 , 000 ` 650
10

ARRB 
 650  100  26 percent
2 , 500

ARRC : Average accounting profit 

 7 , 000  5 , 000 ` 500
4

ARRC 
 500  100  20 percent
2 , 500

b. Summary of Results

Project A B C
Payback (years) 5.5 5.4 2.5
ARR (%) 16 26 20
IRR (%) 12.42 16.72 16.52
NPV (`) 530.50 1,591 655

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Comparison of Rankings

Method Payback ARR IRR NPV

1 C B B B
2 B C C C
3 A A A A

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 PRACTICE QUESTIONS

Source : ICAI, SM (New) - (From Question No. 1 - 4 )

Question 1

Lockwood Limited wants to replace its old machine with a new automatic machine. Two
models A and B are available at the same cost of ` 5 lakhs each. Salvage value of the old
machine is `1 lakh. The utilities of the existing machine can be used if the company
purchases A. Additional cost of utilities to be purchased in that case are ` 1 lakh. If the
company purchases B then all the existing utilities will have to be replaced with new
utilities costing ` 2 lakhs. The salvage value of the old utilities will be ` 0.20 lakhs. The
earnings after taxation are expected to be :

(cash in-flows of)

Year A B P.V. Factor
` ` @ 15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage Value at the end of Year 5 50,000 60,000

The targeted return on capital is 15%. You are required to (i) Compute, for the two machines
separately, net present value, discounted payback period and desirability factor and (ii)
Advice which of the machines is to be selected?

Answer :

1.
(i) Expenditure at year zero (` in lakhs)
Particulars A B
Cost of Machine 5.00 5.00
Cost of Utilities 1.00 2.00
Salvage of Old Machine (1.00) (1.00)
Salvage of Old Utilities – (0.20)
Total Expenditure (Net) 5.00 5.80

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(ii) Discounted Value of Cash inflows

(`in lakhs)
Machine A Machine B
Year NPV Cash Discounted Cash Discounted
Factor inflows value of Flows value of
@ 15% inflows inflows
0 1.00 (5.00) (5.00) (5.80) (5.80)
1 0.87 1.00 0.87 2.00 1.74
2 0.76 1.50 1.14 2.10 1.60
3 0.66 1.80 1.19 1.80 1.19
4 0.57 2.00 1.14 1.70 0.97
5 0.50 1.70 0.85 0.40 0.20
Salvage 0.50 0.50 0.25 0.60 0.30
Net 5.44 6.00
Present (+)0.44 (+)0.20
Value
Since the Net present Value of both the machines is positive both are acceptable.

(iii) Discounted Pay-back Period (`in lakhs)

Machine A Machine B
Year Discounted Cumulative Discounted Cumulative
cash inflows Discounted cash cash inflows Discounted cash
inflows inflows
1 0.87 0.87 1.74 1.74
2 1.14 2.01 1.60 3.34
3 1.19 3.20 1.19 4.53
4 1.14 4.34 0.97 5.50
5 1.10* 5.44 0.50 6.00

* Includes salvage value

Discounted Payback Period (For A and B) :
 0.66 
Machine A  4 years     4.6 years
 110
. 
 0.30 
Machine B  4 years    4.6 years
 0.50 
Sum of present value of net cash inf low
Profitability Index (PI) 
Initial cash outlay

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 INVESTMENT DECISIONS

` 5.44 lakhs ` 6.00 lakhs

Machine A   1.088 Machine B   1.034
` 5.00 lakhs ` 5.80 lakhs

(iv) Since the absolute surplus in the case of A is more than B and also the
desirability factor, it is better to choose A.
The discounted payback period in both the cases is same, also the net
present value is positive in both the cases but the desirability factor (profitability
index) is higher in the case of Machine A, it is therefore better to choose Machine
A.

Question 2

Hind lever Company is considering a new product line to supplement its range of
products. It is anticipated that the new product line will involve cash investments of
`7,00,000 at time 0 and `10,00,000 in year 1. After-tax cash inflows of `2,50,000 are expected
in year 2, `3,00,000 in year 3, `3,50,000 in year 4 and `4,00,000 each year thereafter through
year 10. Although the product line might be viable after year 10, the company prefers to be
conservative and end all calculations at that time.
a. If the required rate of return is 15 per cent, what is the net present value of the project?
Is it acceptable?
b. What would be the case if the required rate of return were 10 per cent?
c. What is its internal rate of return?
d. What is the project’s payback period?

Answer :

a.
Year Cash flow Discount Factor (15%) Present value

(`) (`)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.870 (8,70,000)
2 2,50,000 0.756 1,89,000
3 3,00,000 0.658 1,97,400
4 3,50,000 0.572 2,00,200
5-10 4,00,000 2.163 8,65,200
Net Present Value (1,18,200)

As the net present value is negative, the project is unacceptable.

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b. Similarly, NPV at 10% discount rate can be computed as follows:

Year Cash flow Discount Factor (10%) Present value

(`) (`)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.909 (9,09,000)
2 2,50,000 0.826 2,06,500
3 3,00,000 0.751 2,25,300
4 3,50,000 0.683 2,39,050
5-10 4,00,000 2.974 11,89,600
Net Present Value 2,51,450

Since NPV = `2,51,450 is positive, hence the project would be acceptable

NPV at LR
c. IRR  LR    HR  LR 
NPV at LR  NPV at HR
` 2 , 51, 450
 10%   15%  10%
` 2 , 51, 450     1,18 , 200
= 10% + 3.4012 or 13.40%

d. Payback Period = 6 years:

− ` 7,00, 000 −` 10,00,000 + `2,50,000 + ` 3,00,000 + ` 3,50,000 + ` 4,00,000 + `4,00,000
=0

Question 3

Elite Cooker Company is evaluating three investment situations: (1) produce a new
line of aluminium skillets, (2) expand its existing cooker line to include several new
sizes, and (3) develop a new, higher-quality line of cookers. If only the project in question is
undertaken, the expected present values and the amounts of investment required are:

Project Investment required Present value of Future Cash-Flows

` `
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required
and present values will simply be the sum of the parts. With projects 1 and 3, economies are
SANJAY SARAF SIR 335
 INVESTMENT DECISIONS

possible in investment because one of the machines acquired can be used in both
production processes. The total investment required for projects 1 and 3 combined is
`4,40,000. If projects 2 and 3 are undertaken, there are economies to be achieved in
marketing and producing the products but not in investment. The expected present value
of future cash flows for projects 2 and 3 is `6,20,000. If all three projects are undertaken
simultaneously, the economies noted will still hold. However, a `1,25,000 extension on the
plant will be necessary, as space is not available for all three projects. Which project or
projects should be chosen?

Answer :

Project Investment Present value of Net Present value

Required Future Cash Flows
` ` `
1 2,00,000 2,90,000 90,000
2 1,15,000 1,85,000 70,000
3 10 4,00,000 1.30,000
1 and 2 3,15,000 4,75,000 1,60,000
1 and 3 4,40,000 6,90,000 2,50,000
2 and 3 3,85,000 6,20,000 2,35,000
1, 2 and 3 6,80,000* 9,10,000 2,30,000
(Refer Working note)

Working Note:
i. Total Investment required if all the three projects are undertaken simultaneously:
(`)
Project 1& 3 4,40,000 Project 2
Project 2 1,15,000
Plant extension cost 1,25,000
Total 6,80,000

ii. Total of Present value of Cash flows if all the three projects are undertaken
simultaneously:
(`)
Project 2 & 3 6,20,000
Project 1 2,90,000
Total 9,10,000

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Question 4

Cello Limited is considering buying a new machine which would have a useful economic
life of five years, a cost of `1,25,000 and a scrap value of `30,000, with 80 per cent of the cost
being payable at the start of the project and 20 per cent at the end of the first year. The
machine would produce 50,000 units per annum of a new product with an estimated selling
price of `3 per unit. Direct costs would be `1.75 per unit and annual fixed costs, including
depreciation calculated on a straight- line basis, would be `40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included
in the above costs, would be incurred, amounting to `10,000 and `15,000 respectively.
Evaluate the project using the NPV method of investment appraisal, assuming the
company’s cost of capital to be 10 percent.

Answer :

Calculation of Net Cash flows

Contribution = (3.00 – 1.75) × 50,000 = `62,500
Fixed costs = 40,000 – [(1,25,000 – 30,000)/5] = `21,000

Year Capital (`) Contribution Fixed costs Adverts Net cash

(`) (`) (`) flow (`)
0 (1,00,000) (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 62,500 (21,000) (15,000) 26,500
3 62,500 (21,000) 41,500
4 62,500 (21,000) 41,500
5 30,000 62,500 (21,000) 71,500

Calculation of Net Present Value

Year Net cash flow (`) 10% discount factor Present value (`)
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402

The net present value of the project is ` 31,712.

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 INVESTMENT DECISIONS

Source : ICAI, PM (Old) - (From Question No. 5 - 33 )

Question 5

Company X is forced to choose between two machines A and B. The two machines are
designed differently, but have identical capacity and do exactly the same job. Machine A
costs ` 1,50,000 and will last for 3 years. It costs ` 40,000 per year to run. Machine B is an
‘economy’ model costing only `1,00,000, but will last only for 2 years, and costs ` 60,000 per
year to run. These are real cash flows. The costs are forecasted in rupees of constant
purchasing power. Ignore tax. Opportunity cost of capital is 10 per cent. Which machine
company X should buy?

Answer :

Statement showing the Evaluation of Two Machines

Machines A B
Purchase cost (`): (i) 1,50,000 1,00,000
Life of machines (years) 3 2
Running cost of machine per year (`): (ii) 40,000 60,000
Cumulative present value factor for 1-3 years @ 10%: (iii) 2.486 -
Cumulative present value factor for 1-2 years @ 10%: (iv) - 1.735
Present value of running cost of machines (`): (v) 99,440 1,04,100
[(ii) × (iii)] [(ii) × (iv)]
Cash outflow of machines (`): (vi)=(i) +(v) 2,49,440 2,04,100
Equivalent present value of annual cash outflow 1,00,338 1,17,637
[(vi)÷(iii)] [(vi) ÷(iv)]

Decision: Company X should buy machine A since its equivalent cash outflow is less than
machine B.

Question 6

A company proposes to install a machine involving a Capital Cost of ` 3,60,000. The life of
the machine is 5 years and its salvage value at the end of the life is nil. The machine will
produce the net operating income after depreciation of ` 68,000 per annum. The Company’s
tax rate is 45%.

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The Net Present Value factors for 5 years are as under:

Discounting Rate : 14 15 16 17 18
Cumulative factor : 3.34 3.35 3.27 3.20 3.13

You are required to calculate the internal rate of return of the proposal.

Answer :

Computation of cash inflow per annum `

Net operating income per annum 68,000
Less: Tax @ 45% 30,600
Profit after tax 37,400
Add: Depreciation (` 3,60,000 / 5 years) 72,000
Cash inflow 1,09,400

The IRR of the investment can be found as follows:

NPV= - ` 3,60,000 + ` 1,09,400 (PVAF5, r) = 0
` 3, 60 , 000
or PVA F5 r ( Cumulative factor) =  3.29
` 1, 09 , 400

Computation of internal rate of return

Discounting rate 15% 16%
Cumulative factor 3.35 3.27
Total NPV(` ) 3,66,490 3,57,738
(` 1,09,400 × 3.35) (` 1,09,400 × 3.27)
Internal outlay (` ) 3,60,000 3,60,000
Surplus (Deficit) (` ) 6,490 (2262)

Question 7

The Management of a Company has two alternative proposals under consideration. Project
A requires a capital outlay of ` 12,00,000 and project ‘B” requires `18,00,000. Both are
estimated to provide a cash flow for five years:
Project A ` 4,00,000 per year and Project B ` 5,80,000 per year. The cost of capital is 10%.
Show which of the two projects is preferable from the view point of (i) Net present value
method, (ii) Present value index method (PI method), (iii) Internal rate of return method.
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 INVESTMENT DECISIONS

The present values of Re. 1 of 10%, 18% and 20% to be received annually for 5 years being
3.791, 3. 127 and 2.991 respectively.

Answer :

Recommendations regarding Two Alternative Proposals

i. Net Present Value Method
Computation of Present Value
Project A = ` 4,00,000  3.791 = ` 15,16,400
Project B = ` 5,80,000  3.791 = ` 21,98,780
Computation of Net Present Value
Project A = ` 15,16,400 – 12,00,000 = ` 3,16,400
Project B = ` 21,98,780 – 18,00,000 = ` 3,98,780
Advise: Since the net present value of Project B is higher than that of Project A,
therefore, Project B should be selected.

ii. Present Value Index Method

Pr esent Value of Cash Inflow
Pr esent Value Index 
Initial Investment
15.16, 400
Pr oject   1.264
12, 00, 000
21, 98, 780
Pr oject B   1.222
18, 00, 000
Advise: Since the present value index of Project A is higher than that of Project
B, therefore, Project A should be selected.

iii. Internal Rate of Return (IRR)

Project A
INitial Investment 12 , 00 , 000
P.V. Factor   3
Annual CashInflow 4 , 00 , 000
PV factor falls between 18% and 20%
Present Value of cash inflow at 18% and 20% will be:
Present Value at 18% = 3.127 x 4,00,000 = 12,50,800
Present Value at 20% = 2.991 x 4,00,000 = 11,96,400

50 , 800
 18  2
54 , 400
= 18 + 1.8676 = 19.868 %

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Project B
18 , 00 , 000
P.V. Factor  .
 3103
5 , 80 , 000
Present Value of cash inflow at 18% and 20% will be:
Present Value at 18% = 3.127 x 5,80,000 = 18,13,660
Present Value at 20% = 2.991 x 5,80,000 = 17,34,780

13, 660
 18  2
78 , 880
= 18 + 0.3463 = 18.346 %
Advise: Since the internal rate of return of Project A is higher than that of Project B,
therefore, Project A should be selected.

Question 8

A company wants to invest in a machinery that would cost ` 50,000 at the beginning of year
1. It is estimated that the net cash inflows from operations will be ` 18,000 per annum for 3
years, if the company opts to service a part of the machine at the end of year 1 at ` 10,000. In
such a case, the scrap value at the end of year 3 will be ` 12,500. However, if the company
decides not to service the part, then it will have to be replaced at the end of year 2 at `
15,400. But in this case, the machine will work for the 4th year also and get operational cash
inflow of ` 18,000 for the 4th year. It will have to be scrapped at the end of year 4 at ` 9,000.
Assuming cost of capital at 10% and ignoring taxes, will you recommend the purchase of
this machine based on the net present value of its cash flows?
If the supplier gives a discount of ` 5,000 for purchase, what would be your decision? (The
present value factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091,
0.8264, 0.7513, 0.6830, 0.6209 and 0.5644).

Answer :

Option I : Purchase Machinery and Service Part at the end of Year 1.

Net Present value of cash flow @ 10% per annum discount rate.

= - 50,000 + 18,000 (0.9091 + 0.8264 + 0.7513) – (10,000 × 0.9091) + (12,500 × 0.7513)

= - 50,000 + (18,000 × 2.4868) – 9,091 + 9,391
= - 50,000 + 44,762 – 9,091 + 9,391
NPV = - 4,938

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 INVESTMENT DECISIONS

Since, Net Present Value is negative; therefore, this option is not to be considered.

If Supplier gives a discount of `5,000 then

NPV = +5,000 – 4,938 = + 62
In this case, Net Present Value is positive but very small; therefore, this option may
not be advisable.

Option II : Purchase Machinery and Replace Part at the end of Year 2.

= - 50,000+ 18,000 (0.9091 + 0.8264 + 0.7513) – (15,400 × 0.8264) + (27,000 × 0.6830)

= - 50,000 + 18,000 (2.4868) – (15,400 × 0.8264) + (27,000 × 0.6830)
= - 50,000 + 44,762 – 12,727+ 18,441
= - 62,727+ 63,203 = +476

Net Present Value is positive, but very low as compared to the investment.
If the Supplier gives a discount of ` 5,000, then
NPV = 5,000 + 476 = 5,476

Decision: Option II is worth investing as the net present value is positive and higher as
compared to Option I.

Question 9

A company is required to choose between two machines A and B. The two machines
are designed differently, but have identical capacity and do exactly the same job. Machine
A costs ` 6,00,000 and will last for 3 years. It costs ` 1,20,000 per year to run.
Machine B is an ‘economy’ model costing ` 4,00,000 but will last only for two years, and
costs ` 1,80,000 per year to run. These are real cash flows. The costs are forecasted in rupees
of constant purchasing power. Opportunity cost of capital is 10%. Which machine company
should buy? Ignore tax.
PVIF0.10, 1 = 0.9091, PVIF0. 10, 2 = 0.8264, PVIF0. 10, 3 = 0.7513.

SANJAY SARAF SIR 342

CA INTER FINANCIAL MANAGEMENT

Answer :

Advise to the Management Regarding Buying of Machines

Statement Showing Evaluation of Two Machines
Machines A B
Purchase cost (` ): (i) 6,00,000 4,00,000
Life of machines (years) 3 2
Running cost of machine per year (` ): (ii) 1,20,000 1,80,000
Cumulative present value factor for 1-3 years @ 10%: (iii) 2.4868 -
Cumulative present value factor for 1-2 years @ 10%: (iv) - 1.7355
Present value of running cost of machines (` ): (v) 2,98,416 3,12,390
[(ii) × (iii)] [(ii) × (iv)]
Cash outflow of machines (` ): (vi)=(i) +(v) 8,98,416 7,12,390
Equivalent present value of annual cash outflow 3,61,273.93 4,10,481.13
[(vi)÷(iii)] [(vi) ÷(iv)]

Recommendation : The Company should buy Machine A since its equivalent cash outflow
is less than Machine B.

Question 10

A company has to make a choice between two machines X and Y. The two
machines are designed differently, but have identical capacity and do exactly the same job.
Machine ‘X’ costs ` 5,50,000 and will last for three years. It costs ` 1,25,000 per year to run.
Machine ‘Y’ is an economy model costing ` 4,00,000, but will last for two years and costs `
1,50,000 per year to run. These are real cash flows. The costs are forecasted in Rupees of
constant purchasing power. Opportunity cost of capital is 12%. Ignore taxes. Which
machine company should buy?

t=1 t=2 t=3

PVIF0.12, t 0.8929 0.7972 0.7118
PVIFA0.12,2 = 1.6901
PVIFA0,12,3 = 2.4019

SANJAY SARAF SIR 343

 INVESTMENT DECISIONS

Answer :

Statement showing the Evaluation of Two Machines

Machines X Y
Purchase cost (` ): (i) 5,50,000 4,00,000
Life of Machines (years) 3 2
Running Cost of Machine per year (` ): (ii) 1,25,000 1,50,000
Cumulative Present value factor for 1-3 years @ 10%: (iii) 2.4019 -
Cumulative Present value factor for 1-2 years @ 10%: (iv) - 1.6901
Present Value of Running Cost of Machines (` ): (v) 3,00,237.5 2,53,515
[(ii) × (iii)] [(ii) × (iv)]
Cash Outflow of Machines (` ): (vi)=(i) +(v) 8,50,237.5 6,53,515.0
Equivalent Present Value of Annual Cash Outflow
PV of Machine Cos t 3,53,985.39 3,86,672.39
Equated Annualized Cost 
PVI FA0.12.1

[(vi)÷(iii)] [(vi) ÷(iv)]

Advise: The Company should buy Machine X since its equivalent cash outflow
(` 3,53,985.39) is less than that of Machine Y (` 3,86,672.39).

Question 11

A Company is considering a proposal of installing a drying equipment. The equipment

would involve a Cash outlay of ` 6,00,000 and net Working Capital of ` 80,000. The
expected life of the project is 5 years without any salvage value. Assume that the company
is allowed to charge depreciation on straight-line basis for Income-tax purpose. The
estimated before-tax cash inflows are given below:

Before-tax Cash inflows (` ‘000)

Year 1 2 3 4 5
240 275 210 180 160

The applicable Income-tax rate to the Company is 35%. If the Company’s opportunity Cost
of Capital is 12%, calculate the equipment’s discounted payback period, payback period,
net present value and internal rate of return

SANJAY SARAF SIR 344

CA INTER FINANCIAL MANAGEMENT

The PV factors at 12%, 14% and 15% are:

Year 1 2 3 4 5
PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674
PV factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194
PV factor at 15% 0.8696 0.7561 0.6575 0.5718 0.4972

Answer :

i. Equipment’s initial cost = ` 6,00,000 + 80,000 = ` 6,80,000

ii. Annual straight line depreciation = ` 6,00,000/5 = `1,20,000.
iii. Net cash flows can be calculated as follows:

= Before tax CFs × (1 – Tc) + Tc × Depreciation

(` ‘000)
CFs
Year
0 1 2 3 4 5
1. Initial cost (680)
2. Before tax CFs 240 275 210 180 160
3. Tax @ 35% 84 96.25 73.5 63 56
4. After tax-CFs 156 178.75 136.5 117 104
5. Depreciation tax shield
(Depreciation × Tc) 42 42 42 42 42
6. Working capital released − − − − 80
7. Net Cash Flow (4 + 5 + 6) 198 220.75 178.5 159 226
8. PVF at 12% 1.00 0. 8929 0.7972 0.7118 0.6355 0.5674
9. PV (7 × 8) (680) 176.79 175.98 127.06 101.04 128.23
10. NPV 29.12
0 1 2 3 4 5
PVF at 15% 1 0.8696 0.7561 0.6575 0.5718 0.4972
PV (680) 172.18 166.91 117.36 90.92 112.37
NPV −20.26

SANJAY SARAF SIR 345

 INVESTMENT DECISIONS

Internal Rate of Return

.
2912
IRR  12%   3%  13.77%
49.38

Discounted Payback Period

.
9913
Discounted CFs at K = 12% considered = 176.79 + 175.98 + 127.06 + 101.04 + 12 
128.24
= 4 years and 9.28 months
Payback Period (NCFs are considered)

Question 12

Company UVW has to make a choice between two identical machines, in terms of Capacity,
‘A’ and ‘B’. They have been designed differently, but do exactly the same job.
Machine ‘A’ costs ` 7,50,000 and will last for three years. It costs ` 2,00,000 per year to run.
Machine ‘B’ is an economy model costing only ` 5,00,000, but will last for only two years. It
costs ` 3,00,000 per year to run.
The cash flows of Machine ‘A’ and ‘B’ are real cash flows. The costs are forecasted in rupees
of constant purchasing power. Ignore taxes. The opportunity cost of capital is 9%.

Required:
Which machine the company UVW should buy?
The present value (PV) factors at 9% are:
Year t1 t2 t3
PVIF0.09.t 0.9174 0.8417 0.7722

Answer :
Statement Showing the Evaluation of Two Machines

Machines A B
(i) Purchase Cost ` 7,50,000 ` 5,00,000
(ii) Life of Machine 3 years 2 years
(iii) Running Cost of Machine per year ` 2,00,000 ` 3,00,000
(iv) PVIFA 0.09,3 2.5313
PVIFA 0.09, 2 1.7591
(v) PV of Running Cost of Machine ` 5,06,260 ` 5,27,730
(vi) Cash outflows of Machine {(i) + (v)} ` 12,56,260 ` 10,27,730
(vii) Equivalent PV of Annual Cash outflow (vi/iv) ` 4,96,290 ` 5,84,236
Recommendation : Company UVW should buy Machine ‘A’ since equivalent annual cash
outflow is less than that of Machine B.
SANJAY SARAF SIR 346
CA INTER FINANCIAL MANAGEMENT

Question 13

A company is considering the proposal of taking up a new project which requires an

investment of ` 400 lakhs on machinery and other assets. The project is expected to yield
the following earnings (before depreciation and taxes) over the next five years :

Year Earnings (` in lakhs)

1 160
2 160
3 180
4 180
5 150

The cost of raising the additional capital is 12% and assets have to be depreciated at 20%
on ‘Written Down Value’ basis. The scrap value at the end of the five years’ period may
be taken as zero. Income-tax applicable to the company is 50%.

You are required to calculate the net present value of the project and advise the
management to take appropriate decision. Also calculate the Internal Rate of Return of
the Project.

Note: Present values of Re. 1 at different rates of interest are as follows:

Year 10% 12% 14% 16%

1 0.91 0.89 0.88 0.86
2 0.83 0.80 0.77 0.74
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55
5 0.62 0.57 0.52 0.48

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 INVESTMENT DECISIONS

Answer :

a.
i. Calculation of Net Cash Flow

(` in lakhs)
Year Profit before Depreciation (20% on PBT PAT Net cash
dep. and tax WDV) flow
(1) (2) (3) (4) (5) (3) + (5)
1 160 400 × 20% = 80 80 40 120
2 160 (400 × 80) × 20% = 64 96 48 112
3 180 (320 × 64) × 20% = 51.2 128.8 64.4 115.6
4 180 (256 × 51.2) × 20% = 40.96 139.04 69.52 110.48
5 150 (204.8 × 40.96) = 163.84* - 13.84 - 6.92 156.92

*this is treated as a short term capital loss.

ii. Calculation of Net Present Value (NPV)

(` in lakhs)
Year Net Cash Flow 12% 14% 16%
D.F P.V D.F P.V D.F P.V
1 120 .89 106.8 .88 105.60 .86 103.2
2 112 .80 89.6 .77 86.24 .74 82.88
3 115.6 .71 82.08 .67 77.45 .64 73.98
4 110.48 .64 70.70 .59 65.18 .55 60.76
5 156.92 .57 89.44 .52 81.60 .48 75.32
438.62 416.07 396.14
Less: Initial Investment 400.00 400.00 400.00

NPV 38.62 16.07 - 3.86

iii. Advise: Since Net Present Value of the project at 12% = 38.62 lakhs, therefore the
project should be implemented.

iv. Calculation of Internal Rate of Return (IRR)

.
3214
 14%   14%  1.61%  15.61%
19.93

SANJAY SARAF SIR 348

CA INTER FINANCIAL MANAGEMENT

Question 14

Given below are the data on a capital project 'M'.

Annual cash inflows ` 60,000

Useful life 4 years

Internal rate of return 15%

Profitability index 1.064

Salvage value 0

You are required to calculate for this project M :

(i) Cost of project

(ii) Payback period
(iii) Cost of capital
(iv) Net present value

PV factors at different rates are given below:

Discount factor 15% 14% 13% 12%

1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636

Answer :

(i) Cost of Project ‘M’

At 15% internal rate of return (IRR), the sum of total cash inflows = cost of the project i.e
initial cash outlay
Annual cash inflows = ` 60,000
Useful life = 4 years
Considering the discount factor table @ 15%, cumulative present value of cash
inflows for 4 years is 2.855 (0.869 + 0.756 + 0.658 + 0.572)
Hence, Total Cash inflows for 4 years for Project M is
` 60,000 × 2.855 = ` 1,71,300
Hence, Cost of the Project = ` 1,71,300

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 INVESTMENT DECISIONS

(ii) Payback Period

(iii) Cost of Capital

∴ Sum of Discounted Cash inflows = ` 1,82,263.20

Since, Annual Cash Inflows = ` 60,000
` 1, 82 , 263.20
Hence, cumulative discount factor for 4 years =
` 60 , 000
From the discount factor table, at discount rate of 12%, the cumulative discount factor
for 4 years is 3.038 (0.893 + 0.797 + 0.712 + 0.636)
Hence, Cost of Capital = 12%

(iv) Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ` 1,82,263.20 – ` 1,71,300 = ` 10,963.20
Net Present Value = `10,963.20

Question 15

A large profit making company is considering the installation of a machine to process the
waste produced by one of its existing manufacturing process to be converted into a
marketable product. At present, the waste is removed by a contractor for disposal on
payment by the company of ` 50 lacs per annum for the next four years. The contract can
be terminated upon installation of the aforesaid machine on payment of a compensation
of ` 30 lacs before the processing operation starts. This compensation is not allowed as
deduction for tax purposes.
The machine required for carrying out the processing will cost ` 200 lacs to be financed by a
loan repayable in 4 equal installments commencing from the end of year 1. The interest rate
is 16% per annum. At the end of the 4th year, the machine can be sold for ` 20 lacs and the
cost of dismantling and removal will be ` 15 lacs.
Sales and direct costs of the product emerging from waste processing for 4 years are
estimated as under:

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CA INTER FINANCIAL MANAGEMENT

(` In lacs)
Year 1 2 3 4
Sales 322 322 418 418
Material consumption 30 40 85 85
Wages 75 75 85 100
Other expenses 40 45 54 70
Factory overheads 55 60 110 145
Depreciation (as per income tax rules) 50 38 28 21

Initial stock of materials required before commencement of the processing operations is `

20 lacs at the start of year 1. The stock levels of materials to be maintained at the end of year
1, 2 and 3 will be ` 55 lacs and the stocks at the end of year 4 will be nil. The storage of
materials will utilise space which would otherwise have been rented out for ` 10 lacs per
annum. Labour costs include wages of 40 workers, whose transfer to this process will
reduce idle time payments of ` 15 lacs in the year 1 and `10 lacs in the year 2. Factory
overheads include apportionment of general factory overheads except to the extent of
insurance charges of ` 30 lacs per annum payable on this venture. The company’s tax rate is
50%.
Present value factors for four years are as under:

Year 1 2 3 4
Present value factors 0.870 0.756 0.658 0.572

Advise the management on the desirability of installing the machine for processing the
waste. All calculations should form part of the answer.

SANJAY SARAF SIR 351

 INVESTMENT DECISIONS

Answer :

Statement of Operating Profit

(` in lacs)
Years 1 2 3 4
Sales :(A) 322 322 418 418
Material consumption 30 40 85 85
Wages 60 65 85 100
Other expenses 40 45 54 70
Factory overheads (insurance) 30 30 30 30
Loss of rent 10 10 10 10
Interest 32 24 16 8
Depreciation (as per income tax rules) 50 38 28 21
Total cost: (B) 252 252 308 324
Profit (C)=(A)-(B) 70 70 110 94
Tax (50%) 35 35 55 47
Profit after Tax (PAT) 35 35 55 47

Statement of Incremental Cash Flows

(` in lacs)
Years 0 1 2 3 4
Material stocks (20) (35) - - (55)
Compensation for contract (30) - - - -
Contract payment saved - 50 50 50 50
Tax on contract payment - (25) (25) (25) (25)
Incremental profit - 70 70 110 94
Depreciation added back - 50 38 28 21
Tax on profits - (35) (35) (55) (47)
Loan repayment - (50) (50) (50) (50)
Profit on sale of machinery (net) - - - - 5
Total incremental cash flows (50) 25 48 58 103
Present value factor 1.00 0.870 0.756 0.658 0.572
Net present value of cash flows (50) 21.75 36.288 38.164 58.916
Net present value = ` 155.118 – `50 = 105.118 lacs.

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CA INTER FINANCIAL MANAGEMENT

Advice : Since the net present value of cash flows is ` 105.118 lacs which is positive
the management should install the machine for processing the waste.
Notes:
1. Material stock increases are taken in cash flows.
2. Idle time wages have also been considered
3. Apportioned factory overheads are not relevant only insurance charges of this
project are relevant.
4. Interest calculated at 16% based on 4 equal instalments of loan repayment.
5. Sale of machinery- Net income after deducting removal expenses taken. Tax on
Capital gains ignored.
6. Saving in contract payment and income tax thereon considered in the cash flows.

Question 16

A company has to make a choice between two projects namely A and B. The initial capital
outlay of two Projects are ` 1,35,000 and ` 2,40,000 respectively for A and B. There will be
no scrap value at the end of the life of both the projects. The opportunity Cost of Capital of
the company is 16%. The annual incomes are as under:

Year Project A Project B Discounting factor @ 16%

1 - 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476

You are required to calculate for each project:

(i) Discounted payback period
(ii) Profitability index
(iii) Net present value.

SANJAY SARAF SIR 353

 INVESTMENT DECISIONS

Answer :

Working Notes:

1. Computation of Net Present Values of Projects

Cash flows Discounting Discounted

factor @ 16 % Cash flow
Year Project A Project B Project A Project B
` ` ` `
(1) (2) (3) (3) × (1) (3) × 2)
0 1,35,000 2,40,000 1.000 1,35,000 2,40,000
1 - 60,000 0.862 - 51,720
2 30,000 84,000 0.743 22,290 62,412
3 1,32,000 96,000 0.641 84,612 61,536
4 84,000 1,02,000 0.552 46,368 56,304
5. 84,000 90,000 0.476 39,984 42,840
Net present value 58,254 34,812

2. Computation of Cumulative Present Values of Projects Cash inflows

Project A Project B
PV of cash inflows Cumulative PV of cash Cumulative
Year
PV inflows PV
` ` ` `
1 - - 51,720 51,720
2 22,290 22,290 62,412 1,14,132
3 84,612 1,06,902 61,536 1,75,668
4 46,368 1,53,270 56,304 2,31,972
5 39,984 1,93,254 42,840 2,74,812

(i) Discounted payback period: (Refer to Working note 2)

Cost of Project A = ` 1,35,000
Cost of Project B = ` 2,40,000
Cumulative PV of cash inflows of Project A after 4 years = ` 1,53,270
Cumulative PV of cash inflows of Project B after 5 years = ` 2,74,812

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CA INTER FINANCIAL MANAGEMENT

A comparison of projects cost with their cumulative PV clearly shows that the
project A’s cost will be recovered in less than 4 years and that of project B in less
than 5 years. The exact duration of discounted payback period can be computed as
follows:

Project A Project B
Excess PV of cash inflows over the 18,270 34,812
project cost (` ) (` 1,53,270 - ` 1,35,000) (` 2,74,812 - ` 2,40,000)
Computation of period required 0.39 year 0.81 years
to recover excess amount of (` 18,270 / ` 46,368) (` 34,812 / ` 42,840)
cumulative PV over project cost
(Refer to Working note 2)
Discounted payback period 3.61 year 4.19 years
(4 - 0.39) years (5 - 0.81) years

Sum of discount cash inflows

(ii) Profitability Index: =
Initial cash outflows
` 1,93,254
Profitability Index  for Project A  = =1.43
` 1.35,000
` 2,74,812
Profitability Index  for Project B  = =1.15
` 2,40,000

(iii) Net present value (for Project A) = ` 58,254

(Refer to Working note 1)
Net present value (for Project B) = ` 34,812

Question 17

The cash flows of projects C and D are reproduced below:

Cash Flow NPV

Project C0 C1 C2 C3 IRR
at 10%
C - ` 10,000 + 2,000 + 4,000 + 12,000 + ` 4,139 26.5%
D - ` 10,000 + 10,000 + 3,000 + 3,000 + ` 3,823 37.6%

(i) Why there is a conflict of rankings?

(ii) Why should you recommend project C in spite of lower internal rate of return?

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 INVESTMENT DECISIONS

Period
Time 1 2 3
PVIF0.10, t 0.9090 0.8264 0.7513
PVIF0.14, t 0.8772 0.7695 0.6750
PVIF0.15, t 0.8696 0.7561 0.6575
PVIF0.30, t 0.7692 0.5917 0.4552
PVIF0.40, t 0.7143 0.5102 0.3644

Answer :

(i)
Net Present Value at different discounting rates

Project 0% 10% 15% 30% 40%

` ` ` ` `

8,000 4,139 2,654 -632 - 2,158

{` 2,000 {` 2,000 × 0.909 {` 2,000 × 0.8696 {` 2,000 × 0.7692 {` 2,000
+` 4,000 +` 4,000 × + ` 4,000 × 0.7561 + `4,000× 0.5917 ×0.7143

C +` 12,000 0.8264 + ` 12,000 × + `12,000 × + ` 4,000 ×

-`10,000} +` 12,000 × 0.6575 - ` 10,000} 0.4552 - ` 10,000} 0.5102

0.7513 + ` 12,000 ×
- ` 10,000} 0.3644 -
` 10,000}

Ranking I I II II II
6,000 3,823 2,937 833 - 233
{` 10,000 {` 10,000 × 0.909 {` 10,000 × 0.8696 {` 10,000 × {` 10,000 ×
+` 3,000 +` 3,000 × +` 3,000 × 0.7561 0.7692 0.7143

+` 3,000 0.8264 +` 3,000 × 0.6575 + ` 3,000 × +` 3,000 ×

D
+` 3,000 × 0.5917 0.5102
-` - ` 10,000}
10,000} 0.7513 + ` 3,000 × +` 3,000 ×
- ` 10,000} 0.4552 0.3644
- ` 10,000} - ` 10,000}
Ranking II II I I I

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CA INTER FINANCIAL MANAGEMENT

The conflict in ranking arises because of skewness in cash flows. In the case of Project C
cash flows occur later in the life and in the case of Project D, cash flows are
skewed towards the beginning.
At lower discount rate, project C’s NPV will be higher than that of project D. As the
discount rate increases, Project C’s NPV will fall at a faster rate, due to compounding effect.
After break even discount rate, Project D has higher NPV as well as higher IRR.

(ii) If the opportunity cost of funds is 10%, project C should be accepted because the firm’s
wealth will increase by ` 316 (` 4,139 ` 3,823)
The following statement of incremental analysis will substantiate the above point.

Cash Flows (` ) NPV at IRR

Project C0 C1 C2 C3 10% 12.5%
` ` ` `
C-D 0 -8,000 1,000 9,000 316 0
{-8,000 × 0.909 {-8,000 × 0.88884
+1,000 × 0.8264 + 1,000 × 0.7898
+ 9,000 × 0.7513} + 9,000 × 0.7019}

Hence, the project C should be accepted, when opportunity cost of funds is 10%.

Question 18

The cash flows of two mutually exclusive Projects are as under:

t0 t1 t2 t3 t4 t5 t6
Project ‘P’ (` ) (40,000) 13,000 8,000 14,000 12,000 11,000 15,000

Project ‘J’ (` ) (20,000) 7,000 13,000 12,000 - - -

Required:
i. Estimate the net present value (NPV) of the Project ‘P’ and ‘J’ using 15% as the
hurdle rate.
ii. Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
iii. Why there is a conflict in the project choice by using NPV and IRR criterion?
iv. Which criteria you will use in such a situation? Estimate the value at that criterion.
Make a project choice.
The present value interest factor values at different rates of discount are as under:

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 INVESTMENT DECISIONS

Rate of t0 t1 t2 t3 t4 t5 t6
discount
0.15 1.00 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
0.18 1.00 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704
0.20 1.00 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349
0.24 1.00 0.8065 0.6504 0.5245 0.4230 0.3411 0.2751
0.26 1.00 0.7937 0.6299 0.4999 0.3968 0.3149 0.2499

Answer :

i. Estimation of net present value (NPV) of the Project ‘P’ and ‘J ’ using 15% as the hurdle
rate:
NPV of Project ‘P’ :

= - 40,000 + 11,304.35 + 6,049.15 + 9,205.68 + 6,861.45 + 5,469.37 + 6,485.65

= ` 5,375.65 or ` 5,376
NPV of Project ‘J ’ :

= - 20,000 + 6,086.96 + 9,829.87 + 7,890.58

= ` 3,807.41

ii. Estimation of internal rate of return (IRR) of the Project ‘P ‘ and ‘ J ‘

Internal rate of return r (IRR) is that rate at which the sum of cash inflows after
discounting equals to the discounted cash out flows. The value of r in the case of
given projects can be determined by using the following formula:

Where,
Co = Cash flows at the time O
CFt = Cash inflow at the end of year t
r = Discount rate
n = Life of the project
SV & WC = Salvage value and working capital at the end of n years.
In the case of project ‘P’ the value of r (IRR) is given by the following relation:

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CA INTER FINANCIAL MANAGEMENT

r = 19.73%
Similarly we can determine the internal rate of return for the project ‘J’. In the case of
project ‘J’ it comes to:
r = 25.20%

iii. The conflict between NPV and IRR rule in the case of mutually exclusive project
situation arises due to re-investment rate assumption. NPV rule assumes that
intermediate cash flows are reinvested at k and IRR assumes that they are reinvested
at r. The assumption of NPV rule is more realistic.

iv. When there is a conflict in the project choice by using NPV and IRR criterion, we would
prefer to use “Equal Annualized Criterion”. According to this criterion the net annual
cash inflow in the case of Projects ‘P’ and ‘J’ respectively would be:
Project ‘P’ = (Net present value/ cumulative present value of Re.1 p.a.
@ 15% for 6 years
= (` 5,375.65 / 3.7845) = ` 1,420.44
Project ‘J’ = (` 3807.41/2.2832) = ` 1667.58

Advise : Since the cash inflow per annum in the case of project ‘J’ is more than that of
project ‘P’, so Project J is recommended.

Question 19

MNP Limited is thinking of replacing its existing machine by a new machine which would
cost ` 60 lakhs. The company’s current production is ` 80,000 units, and is expected to
increase to 1,00,000 units, if the new machine is bought. The selling price of the product
would remain unchanged at ` 200 per unit. The following is the cost of producing one unit
of product using both the existing and new machine:
Unit cost (` )
Existing Machine New Machine Difference
(80,000 units) (1,00,000 units)
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.0 25.0 5.0
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate 10.0 12.50 2.50
Overheads
183.25 165.50 (17.75)

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 INVESTMENT DECISIONS

The existing machine has an accounting book value of ` 1,00,000, and it has been
fully depreciated for tax purpose. It is estimated that machine will be useful for 5 years.
The supplier of the new machine has offered to accept the old machine for ` 2,50,000.
However, the market price of old machine today is ` 1,50,000 and it is expected to be `
35,000 after 5 years. The new machine has a life of 5 years and a salvage value of ` 2,50,000
at the end of its economic life. Assume corporate Income tax rate at 40%, and depreciation
is charged on straight line basis for Income-tax purposes. Further assume that book profit
is treated as ordinary income for tax purpose. The opportunity cost of capital of the
Company is 15%.

Required:
i. Estimate net present value of the replacement decision.
ii. Estimate the internal rate of return of the replacement decision.
iii. Should Company go ahead with the replacement decision? Suggest.

Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

Answer :

i. Initial Cash Outflow:

Amount (`)
Cost of new machine 60,00,000
Less: Sale Price of existing machine 1,50,000
Net of Tax (`2,50,0100 × 0.60)
58,50,000

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CA INTER FINANCIAL MANAGEMENT

ii. Terminal Cash Flows:

a. New Machine

Amount (`)
Salvage value of Machine 2,50,000
Less: Depreciated WDV 2,50,000
{` 60,00,000 - (`11,50,000 × 5 years)}
STCG Nil
Tax Nil
Net Salvage Value (cash flows) 2,50,000

b. Old Machine
Cash realised on disposal of existing machine after ` 35,000 Additional cash flows
at terminal year = ` 2,15,000 (2,50,000-35,000)

iii. Calculation of Net Cash Flows

Particulars Existing Machine New Machine Incremental

1. Production 80,000 Units 1,00,000 Units 20,000 Units

(`) (`) (`)
2. Selling Price 200 200
3. Variable Cost 173 148
4. Earnings before
depreciation and Tax 27 52
per Unit
5. Total earnings
21,60,000 52,00,000 30,40,000
before depreciation and
Tax(1*4)
6. Less: Depreciation
 60 , 00 , 000  2 , 50 , 000  11,50,000
 
5

7. Earning after
18,90,000
depreciation before
Tax
8. Less: Tax @40% 7,56,000

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 INVESTMENT DECISIONS

9. Earning after
11,34,000
depreciation and
Tax
10 .Add: Depreciation 11,50,000
11. Net Cash inflow 22,84,000

Alternatively

(iii) Computation of additional cash flows (yearly)

Particulars Amount (`) Amount (`)

Sales 1,60,00,000 2,00,00,000
Material 60,00,000 63,75,000
Wages & Salaries 41,00,000 37,50,000
Supervision 16,00,000 25,00,000
Repair & Maintenance 9,00,000 7,50,000
Power & fuel 12,40,000 14,25,000
Depreciation -- 11,50,000
Total cost 1,38,40,000 1,59,50,000
Profit(Sales – Total cost) 21,60,000 40,50,000
Less: Tax@40% 8,64,000 16,20,000
12,96,000 24,30,000
Add: Depreciation ** 11,50,000*
12,96,000 35,80,000
Incremental Cash inflow 22,84,000

** As mention in the question WDV of Machine is zero for tax purpose hence no
depreciation shall be provided in existing machine.

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CA INTER FINANCIAL MANAGEMENT

(iv) Computation of NPV @ 15%

Period Cash flow (`) PVF PV (`)

Incremental cash flows 1-5 22,84,000 3.352 76,55,968
Add; Terminal year cash
5 2,15,000 0.4972 1,06,898

77,62,866
Less: Additional cash outflow 0 58,50,000 1
58,50,000

NPV 19,12,866

(v) Calculation of IRR

(ii) IRR- Since NPV computed in Part (i) is positive. Let us discount cash flows at higher
rate say at 30%

Period Cash flow (`) PVF PV (`)

Incremental cash flows 1-5 22,84,000 2.436 55,63,824
Add: Terminal year cash 5 2,15,000 0.2693 57,900
55,05,924

Less: Additional cash 0 58,50,000 1 58,50,000

outflow
NPV - 3,44,076

Now we use interpolation formula

19 ,12 , 866
15%   15%
19 ,12 , 866   3 , 44 , 076 
19 ,12 , 866
15%   15%
22 , 56 , 942
= 15% + 12.71% = 27.71%

SANJAY SARAF SIR 363

 INVESTMENT DECISIONS

Question 20

Consider the following mutually exclusive projects:

Cash flows (` )
Projects C0 C1 C2 C3 C4
A - 10,000 6,000 2,000 2,000 12,000
B - 10,000 2,500 2,500 5,000 7,500
C - 3,500 1,500 2,500 500 5,000
D - 3,000 0 0 3,000 6,000

Required:
(i) Calculate the payback period for each project.
(ii) If the standard payback period is 2 years, which project will you select? Will your
answer differ, if standard payback period is 3 years?
(iii) If the cost of capital is 10%, compute the discounted payback period for each
project. Which projects will you recommend, if standard discounted payback period is
(i) 2 years; (ii) 3 years?
(iv) Compute NPV of each project. Which project will you recommend on the NPV
criterion? The cost of capital is 10%. What will be the appropriate choice criteria in this
case? The PV factors at 10% are:

Year 1 2 3 4
PV factor at 10% 0.9091 0.8264 0.7513 0.6830
(PV/F 0.10, t)

Answer :

(i) Payback Period of Projects

C0 C1 C2 C3
A - 10,000 + 6,000 + 2,000 + 2,000 = 3 years
B - 10,000 + 2,500 + 2,500 + 5,000 = 3 years
C - 3,500 + 1,500 + 2,500 = 1 year and 9.6 months
12
i.e.  2 , 000
2 , 500
D - 3,000 + 0 + 0+ 3,000 = 3 years.

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CA INTER FINANCIAL MANAGEMENT

(ii) If standard payback period is 2 years, Project C is the only acceptable project.
But if standard payback period is 3 years, all the four projects are acceptable.

(iii) Discounted Payback Period (Cash flows discounted at 10%)

A - 10,000 + 5,454.6 + 1,652.8 + 1,502.6 + 8,196

B - 10,000 + 2,272.75 + 2,066 + 3,756.5 + 5,122.50

C - 3,500 + 1,363.65 + 2,066 + 375.65 + 3,415

D - 3,000 + 0 + 0 + 2,253.9 + 4,098

If standard discounted payback period is 2 years, no project is acceptable on

discounted payback period criterion.
If standard discounted payback period is 3 years, Project ‘C’ is acceptable on
discounted payback period criterion.

(iv) Evaluation of Projects on NPV criterion

A = - 10,000 + 5,454.6 + 1,652.8 + 1,502.60 + 8,196
NPV = ` 6,806.2
B = - 10,000 + 2,272.75 + 2,066 + 3,756.5 + 5,122.5
NPV = ` 3,217.75
C = - 3,500 + 1,363.65 + 2,066 + 3, 75.65 + 3,415
NPV = ` 3,720.3
D = - 3,000 + 0 + 0 + 2,253.9 + 4,098
NPV = ` 3,351.9
Ranking of Projects on NPV Criterion

NPV Rank
`
A 6,806.2 I
B 3,217.75 IV
C 3,720.3 II
D 3,351.9 III

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 INVESTMENT DECISIONS

Analysis : Project A is acceptable under the NPV method. The NPV technique is superior
to any other technique of capital budgeting, whether it is PI or IRR. The best project is the
one which adds the most, among available alternatives, to the shareholders wealth.
The NPV method, by its very definition, will always select such projects. Therefore,
the NPV method gives a better mutually exclusive choice than PI method. The NPV
method guarantees the choice of the best alternative.

Question 21

A firm can make investment in either of the following two projects. The firm anticipates its
cost of capital to be 10% and the net (after tax) cash flows of the projects for five years are as
follows:
(Figures in ` ‘000)

Year 0 1 2 3 4 5
Project-A (500) 85 200 240 220 70
Project-B (500) 480 100 70 30 20

The discount factors are as under

Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
PVF (20%) 1 0.83 0.69 0.58 0.48 0.41

Required:
i. Calculate the NPV and IRR of each project.
ii. State with reasons which project you would recommend.
iii. Explain the inconsistency in ranking of two projects.

Answer :
i. Computation of NPV and IRR
For Project A:
Years Cash flows` ’000 PVF 10% P.V.` ’000 PVF 20% P.V.` ’000
0 -500 1.00 - 500.00 1.00 -500.00
1 85 0.91 77.35 0.83 70.55
2 200 0.83 166.00 0.69 138.00
3 240 0.75 180.00 0.58 139.20
4 220 0.68 149.60 0.48 105.60
5 70 0.62 43.40 0.41 28.70
NPV +116.35 -17.95

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CA INTER FINANCIAL MANAGEMENT

NPV of Project A at 10% (Cost of Capital) is ` 1,16,350.

IRR of Project A may be calculated by interpolation method as under:
NPV at 20% is (-) 17.95 (` ’000)
NPV at 10% is + 116.35 (` ’000)

= 18.66%

For Project B:

Years Cash flows PVF P.V. PVF P.V.

(` ’000) 10% (` ’000) 20% (` ’000)
0 - 500 1.00 - 500 1.00 500
1 480 0.91 436.80 0.83 398.40
2 100 0.83 83.00 0.69 69.00
3 70 0.75 52.50 0.58 40.60
4 30 0.68 20.40 0.48 14.40
5 20 0.62 12.40 0.41 8.20
NPV +105.10 + 30.60

NPV of Project B at 10% (Cost of Capital) is ` 1,05,100.

IRR of Project B is calculated by interpolation method as under:
NPV at 10% = + 105.10 (` ’000)
NPV at 20% = + 30.60 (` ’000)

(Note: Though in above solution discounting factors of 10% and 20% have
been used. However, instead of 20%, students may assume any rate beyond 20%,
say 26%, and then NPV becomes negative. In such a case, the answers of IRR of
Project may slightly vary from 24.10%.)

ii. The ranking of the projects will be as under:

NPV IRR
Project A 1 2
Project B 2 1

There is a conflict in ranking. IRR assumes that the project cash flows are reinvested
at IRR whereas the cost of capital is 10%. The two projects are mutually exclusive.

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 INVESTMENT DECISIONS

In the circumstances, the project which yields the larger NPV will earn larger cash
flows. Hence the project with larger NPV should be chosen. Thus Project A
qualifies for selection.

iii. Inconsistency in ranking arises because if NPV criterion is used, Project A is

preferable. If IRR criterion is used, Project B is preferable. The inconsistency is due
to the difference in the pattern of cash flows.
Where an inconsistency is experienced, the projects yielding larger NPV is
preferred because of larger cash flows which it generates. IRR criterion is rejected
because of the following reasons:
(a) IRR assumes that all cash flows are re-invested at IRR.
(b) IRR is a percentage but the magnitude of cash flow is important.
(c) Multiple IRR may arise if the projects have non-conventional cash flows.

Question 22

WX Ltd. has a machine which has been in operation for 3 years. Its remaining estimated
useful life is 8 years with no salvage value in the end. Its current market value is ` 2,00,000.
The company is considering a proposal to purchase a new model of machine to replace the
existing machine. The relevant information is as follows:

Existing Machine New Machine

Cost of machine ` 3,30,000 ` 10,00,000
Estimated life 11 years 8 years
Salvage value Nil ` 40,000
Annual output 30,000 units 75,000 units
Selling price per unit ` 15 ` 15
Annual operating hours 3,000 3,000
Material cost per unit `4 `4
Labour cost per hour* ` 40 ` 70
Indirect cash cost per annum ` 50,000 ` 65,000

The company follow the straight line method of depreciation. The corporate tax rate is 30
per cent and WX Ltd. does not make any investment, if it yields less than 12 per cent.
Present value of annuity of Re. 1 at 12% rate of discount for 8 years is 4.968. Present value
of ` 1 at 12% rate of discount, received at the end of 8th year is 0.404. Ignore capital gain
tax.

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CA INTER FINANCIAL MANAGEMENT

Advise WX Ltd. whether the existing machine should be replaced or not.

* In the question paper this word was wrongly printed as ‘unit’ instead of word ‘hour’. The
answer provided here is on the basis of correct word i.e. ‘Labour cost per hour’.

Answer :

(i) Calculation of Net Initial Cash Outflows:

`
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 2,00,000
Net initial cash outflows 8,00,000

(ii) Calculation of annual depreciation:

(iii) Calculation of annual cash inflows from operation:

Particulars Existing machine New Machine Differential

(1) (2) (3) (4) =(3) – (2)

Annual output 30,000 units 75,000 units 45,000 units
` ` `
(A) Sales revenue @ ` 15 per unit
4,50,000 11,25,000 6,75,000
(B) Less: Cost of Operation
Material @ ` 4 per unit 1,20,000 3,00,000 1,80,000
Labour
Old = 3,000 × ` 40 1,20,000 90,000
New = 3,000 × ` 70 2,10,000
Indirect cash cost 50,000 65,000 15,000
Depreciation 30,000 1,20,000 90,000
Total Cost (B) 3,20,000 6,95,000 3,75,000
Profit Before Tax (A – B) 1,30,000 4,30,000 3,00,000
Less: Tax @ 30% 39,000 1,29,000 90,000
Profit After Tax 91,000 3,01,000 2,10,000
Add: Depreciation 30,000 1,20,000 90,000
Annual Cash Inflows 1,21,000 4,21,000 3,00,000

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 INVESTMENT DECISIONS

(iv) Calculation of Net Present Value

`
Present value of annual net cash
Inflows: 1 – 8 years = ` 3,00,000 × 4.968 14,90,400
Add: Present value of salvage value of new machine at
the end of 8th year (` 40,000 × 0.404) 16,160
Total present value 15,06,560
Less: Net Initial Cash Outflows 8,00,000
NPV 7,06,560

Alternative Solution:

Calculation of Net Present Value (NPV)

Particulars Period Cash Flow Present Value Present Value

(Year) (` ) Factor (PVF) (` )
@ 12%
Purchase of new machine 0 - 8,00,000 1.00 - 8,00,000
Incremental Annual Cash Inflow 1–8 3,00,000 4.968 14,90,400
Salvage value of new machine 8 40,000 0.404 16,160
Net Present Value (NPV) 7,06,560

Advise : Hence, existing machine should be replaced because NPV is positive.

Question 23

Given below are the data on a capital project ‘M’:

Annual cost saving ` 60,000
Useful life 4 years
Internal rate of return 15 %
Profitability index 1.064
Salvage value 0

You are required to calculate for this project M:

i. Cost of project
ii. Payback period
iii. Cost of capital
iv. Net present value.
SANJAY SARAF SIR 370
CA INTER FINANCIAL MANAGEMENT

Given the following table of discount factors:

Discount 15% 14% 13% 12%
factor
1 year 0.869 0.877 0.885 0.893
2 years 0.756 0.769 0.783 0.797
3 years 0.658 0.675 0.693 0.712
4 years 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038

Answer :

a.
i. Cost of Project ‘M’
At 15% internal rate of return (IRR), the sum of total cash inflows = cost of the project
i.e initial cash outlay
Annual cost savings = ` 60,000
Useful life = 4 years
Considering the discount factor table @ 15%, cumulative present value of cash
inflows for 4 years is 2.855
Hence, Total Cash inflows for 4 years for Project M is
60,000 x 2.855 = ` 1,71, 300
Hence, Cost of the Project = ` 1,71,300

ii. Payback Period

Payback Period = 2.855 years

iii. Cost of Capital

∴ Sum of Discounted Cash inflows = ` 1,82,263.20

Since, Annual Cost Saving = ` 60,000
` 1, 82 , 263.20
Hence, cumulative discount factor for 4 years =
60 , 000

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 INVESTMENT DECISIONS

From the discount factor table, at discount rate of 12%, the cumulative discount
factor for 4 years is 3.038
Hence, Cost of Capital = 12%

iv. Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ` 1,82,263.20 – 1,71,300 = ` 10,963.20
Net Present Value = ` 10,963.20

Question 24

PR Engineering Ltd. is considering the purchase of a new machine which will carry out
some operations which are at present performed by manual labour. The following
information related to the two alternative models – ‘MX’ and ‘MY’ are available:

Machine ‘MX’ Machine ‘MY’

Cost of Machine ` 8,00,000 ` 10,20,000
Expected Life 6 years 6 years
Scrap Value ` 20,000 ` 30,000

Estimated net income before depreciation and tax:

Year ` `
1 2,50,000 2,70,000
2 2,30,000 3,60,000
3 1,80,000 3,80,000
4 2,00,000 2,80,000
5 1,80,000 2,60,000
6 1,60,000 1,85,000

Corporate tax rate for this company is 30 percent and company’s required rate of return on
investment proposals is 10 percent. Depreciation will be charged on straight line basis.

You are required to:

i. Calculate the pay-back period of each proposal.
ii. Calculate the net present value of each proposal, if the P.V. factor at 10% is – 0.909,
0.826, 0.751, 0.683, 0.621 and 0.564.
iii. Which proposal you would recommend and why?

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CA INTER FINANCIAL MANAGEMENT

Answer :

a. Working Notes:
1. Annual Depreciation of Machines
` 8 , 00 , 000 ` 20 , 000
Depreciation of Machine ‘MX = ` 1, 30 , 000
6
`10 , 20 , 000  `3 0 , 000
Depreciation of Machine ‘MY =  ` 1, 65 , 000
6
Calculation of Cash Inflows
Machine ‘MX’ Years
1 2 3 4 5 6
Income before 2,50,000 2,30,000 1,80,000 2,00,000 1,80,000 1,60,000
Depreciation & Tax
Less: Depreciation 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000
Profit before Tax 1,20,000 1,00,000 50,000 70,000 50,000 30,000
Less : Tax @ 30% 36,000 30,000 15,000 21,000 15,000 9,000
Profit after Tax (PAT) 84,000 70,000 35,000 49,000 35,000 21,000
Add: Depreciation 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000
Cash Inflows 2,14,000 2,00,000 1,65,000 1,79,000 1,65,000 1,51,000

Machine ‘MY’ Years

1 2 3 4 5 6
Income before 2,70,000 3,60,000 3,80,000 2,80,000 2,60,000 1,85,000
Depreciation &
Tax
Less: Depreciation 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000

Profit before Tax 1,05,000 1,95,000 2,15,000 1,15,000 95,000 20,000

Less : Tax @ 30% 31,500 6,000
58,500 64,500 34,500 28,500
Profit after Tax 73,500 1,36,500 1,50,500 80,500 66,500 14,000
(PAT)
Add: Depreciation 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000
Cash Inflows 2,38,500 3,01,500 3,15,500 2,45,500 2,31,500 1,79,000

SANJAY SARAF SIR 373

 INVESTMENT DECISIONS

i. Calculation of Payback Period

Cumulative Cash Inflows

Years
1 2 3 4 5 6
Machine 2,14,000 4,14,000 5,79,000 7,58,000 9,23,000 10,74,000
‘MX’
Machine 2,38,500 5,40,000 8,55,500 11,01,000 13,32,500 15,11,500
‘MY’

Pay-back Period for ‘MX’

 4
8 , 00 , 000  7 , 58 , 000
1, 65 , 000
= 4.25 years or 4 years and 3 months.

Pay-back Period for ‘MY’

 3
10 , 20 , 000  8 , 55 , 000  3  0.67  3.67 years
2 , 45 , 500
Or, 3 years and 8 months.

ii. Calculation of Net Present Value (NPV)

Machine ‘MX’ Machine ‘MY’
Year PV Cash Present Cash Present
Factor Inflows Value Inflows Value
` ` ` `
0 1.000 (8,00,000) (8,00,000) (10,20,000) (10,20,000)
1 0.909 2,14,000 1,94,526 2,38,500 2,16,797
2 0.826 2,00,000 1,65,200 3,01,500 2,49,039
3 0.751 1,65,000 1,23,915 3,15,500 2,36,941
4 0.683 1,79,000 1,22,257 2,45,500 1,67,677
5 0.621 1,65,000 1,02,465 2,31,500 1,43,762
6 0.564 1,51,000 85,164 1,79,000 1,00,956
Scrap Value 0.564 20,000 11,280 30,000 16,920
Net Present Value(NPV) 4,807 1,12,092

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CA INTER FINANCIAL MANAGEMENT

iii. Recommendation

Machine ‘MX’ Machine ‘MY’

Ranking according to Pay-back Period II I
Ranking according to Net Present Value (NPV) II I

Advise: Since Machine ‘MY’ has higher ranking than Machine ‘MX’ according to
both parameters, i.e. Payback Period as well as Net Present Value, therefore, Machine
‘MY’ is recommended.

Question 25

A Ltd. is considering the purchase of a machine which will perform some operations which
are at present performed by workers. Machines X and Y are alternative models. The
following details are available:

Machine X Machine Y
(` ) (` )
Cost of machine 1,50,000 2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance p.a. 7,000 11,000
Estimated cost of indirect material, p.a. 6,000 8,000
Estimated savings in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated savings in wages pa. 90,000 1,20,000

Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the
alternatives according to:
i. Average rate of return method, and
ii. Present value index method assuming cost of capital being 10%
(The present value of ` 1.00 @ 10% p.a. for 5 years is 3.79 and for 6 years is 4.354)

Answer :

Working Notes:
1, 50 , 000
Depreciation on Machine X  ` 30 , 000
5
2 , 40 , 000
Depreciation on Machine Y  `4 0 , 000
6
SANJAY SARAF SIR 375
 INVESTMENT DECISIONS

Particulars Machine X (`) Machine Y (`)

Annual Savings:
Wages 90,000 1,20,000
Scrap 10,000 15,000
Total Savings (A) 1,00,000 1,35,000
Annual Estimated Cash Cost :
Indirect Material 6,000 8,000
Supervision 12,000 16,000
Maintenance 7,000 11,000
Total Cash Cost (B) 25,000 35,000
Annual Cash Savings (A-B) 75,000 1,00,000
Less : Depreciation 30,000 40,000
Annual Savings Before Tax 45,000 60,000
Less : Tax @ 30% 13,500 18,000
Annual Savings/Profit (After Tax) 31,500 42,000
Add : Depreciation 30,000 40,000
Annual Cash Inflows 61,500 82,000

Evaluation of Alternatives

(i) Average Rate of Return Method (ARR)

Decision : Machine X is better.

[Note: ARR can be computed alternatively taking initial investment as the
basis for computation (ARR = Average Annual Net Income/Initial Investment).
The value of ARR for Machines X and Y would then change accordingly as 21%
and 17.5% respectively]

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CA INTER FINANCIAL MANAGEMENT

(ii) Present Value Index Method

Present Value of Cash Inflow = Annual Cash Inflow x P.V. Factor @ 10%
Machine X = 61,500 × 3.79
= ` 2,33,085
Machine Y = 82,000 x 4.354
= ` 3,57,028
Pr esent Vlaue of Cash inf low
P.V. Index 
Investment
2 , 33, 085
Machine X   1.5539
1, 50 , 000
3, 57 , 028
Machine Y   1.4876
2 , 40 , 000
Decision : Machine X is better.

Question 26

XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project
is to be set up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free
subsidy from the State Government of ` 25,00,000 on capital investment. Initial equipment
cost will be ` 1.75 crores. Additional equipment costing ` 12,50,000 will be purchased at the
end of the third year from the cash inflow of this year. At the end of 8 years, the original
equipment will have no resale value, but additional equipment can be sold for ` 1,25,000. A
working capital of ` 20,00,000 will be needed and it will be released at the end of eighth
year. The project will be financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows:

Year 1 2 3 4-5 6-8

Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of ` 120 per unit is expected and variable expenses will amount to 60% of sales
revenue. Fixed cash operating costs will amount ` 18,00,000 per year. The loss of any year
will be set off from the profits of subsequent two years. The company is subject to 30 per
cent tax rate and considers 12 per cent to be an appropriate after tax cost of capital for this
project. The company follows straight line method of depreciation.
Required:
Calculate the net present value of the project and advise the management to take
appropriate decision.

SANJAY SARAF SIR 377

 INVESTMENT DECISIONS

Note:
The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
.893 .797 .712 .636 .567 .507 .452 .404

Answer :
(`’000)
Year Sales VC FC Dep. Profit Tax PAT Dep. Cash
inflow
1 86.40 51.84 18 21.875 (5.315) - - 21.875 16.56
2 129.60 77.76 18 21.875 11.965 1.995* 9.97 21.875 31.845
3 312.00 187.20 18 21.875 84.925 25.4775 59.4475 21.875 81.3225
4-5 324.00 194.40 18 24.125 87.475 26.2425 61.2325 24.125 85.3575
6-8 216.00 129.60 18 24.125 44.275 13.2825 30.9925 24.125 55.1175

* (30% of 11.965 – 30% of 5.315) = 3.5895 – 1.5945 = 1.995)

`
Cost of New Equipment 1,75,00,000
Less: Subsidy 25,00,000
Add: Working Capital 20,00,000
Outflow 1,70,00,000

Calculation of NPV

Year Cash inflows PV factor NPV

(` ) (` )
1 16,56,000 .893 14,78,808
2 31,84,500 .797 25,38,047
3 81,32,250 - 12,50,000 = 68,82,250 .712 49,00,162
4 85,35,750 .636 54,28,737
5 85,35,750 .567 48,39,770
6 55,11,750 .507 27,94,457
7 55,11,750 .452 24,91,311
8 55,11,750 + 20,00,000 + 1,25,000 = 76,36,750 .404 30,85,247
Net Present Value 2,75,56,539

SANJAY SARAF SIR 378

CA INTER FINANCIAL MANAGEMENT

NPV 2,75,56,539
Less: Out flow 1,70,00,000
Saving 1,05,56,539

Advise: Since the project has a positive NPV, therefore, it should be accepted.

Question 27

C Ltd. is considering investing in a project. The expected original investment in the project
will be ` 2,00,000, the life of project will be 5 year with no salvage value. The expected profit
after depreciation but before tax during the life of the project will be as following:

Year 1 2 3 4 5
` 85,000 1,00,000 80,000 80,000 40,000

The project will be depreciated at the rate of 20% on original cost. The company is subjected
to 30% tax rate.

Required:
i. Calculate payback period and average rate of return (ARR)
ii. Calculate net present value and net present value index, if cost of capital is 10%.
iii. Calculate internal rate of return.
Note: The P.V. factors are:

Year P.V. at 10% P.V. at 37% P.V. at 38% P.V. at 40%

1 .909 .730 .725 .714
2 .826 .533 .525 .510
3 .751 .389 .381 .364
4 .683 .284 .276 .260
5 .621 .207 .200 .186

SANJAY SARAF SIR 379

 INVESTMENT DECISIONS

Answer :

Project Outflow 2,00,000

Year 1 2 3 4 5
` ` ` ` `

Profit after
depreciation but 85,000 1,00,000 80,000 80,000 40,000
before tax
Less: Tax (30 %) 25,500 30,000 24,000 24,000 12,000
PAT 59,500 70,000 56,000 56,000 28,000 Average = ` 53,900
Add: Dep. 40,000 40,000 40,000 40,000 40,000
Net cash inflow 99,500 1,10,000 96,000 96,000 68,000 Average = `
93,900.

i. Calculation of payback period

1, 00 , 500
 1  1.914
1,10 , 000

ii. Calculation of ARR

Initial investment 2,00,000 1,60,000 1,20,000 80,000 40,000
Depreciation 40,000 40,000 40,000 40,000 40,000
Closing investment 1,60,000 1,20,000 80,000 40,000 0
Average 1,80,000 1,40,000 1,00,000 60,000 20,000 Average=1,00,000
investment

53, 900
ARR = Average of profit after tax / Average investment   53.90%
1, 00 , 000

iii. Calculation of net present Value 10%

Net cash inflow 99,500.00 1,10,000.00 96,000.00 96,000.00 68,000.00

0.909 0.826 0.751 0.683 0.621
Present value 90,445.50 90,860.00 72,096.00 65,568.00 42,228.00 3,61,197.50

SANJAY SARAF SIR 380

CA INTER FINANCIAL MANAGEMENT

Net present value = ` 3,61,197.50 – ` 2,00,000 = ` 1,61,197.50

iv. Calculation of IRR

Present value factor-Initial investment / Average annual cash inflow
2,00,000 / 93,900 = 2.13
It lies in between 38 % and 40%

IRR is calculated by Interpolation:

IRR = LDR + (P1 - Q) / P1 - P2 (SDR - LDR)
= 38 + (2,06,559.50 - 2,00,000) / (2,06,559.50 - 1,99,695) × (40 - 38)
= 39.911137% = 39.91%

Question 28

A hospital is considering to purchase a diagnostic machine costing ` 80,000. The projected

life of the machine is 8 years and has an expected salvage value of ` 6,000 at the end of 8
years. The annual operating cost of the machine is ` 7,500. It is expected to generate
revenues of ` 40,000 per year for eight years. Presently, the hospital is outsourcing the
diagnostic work and is earning commission income of ` 12,000 per annum; net of taxes.

Required:
Whether it would be profitable for the hospital to purchase the machine? Give your
recommendation under:
(i) Net Present Value method
(ii) Profitability Index method.
PV factors at 10% are given below:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

SANJAY SARAF SIR 381

 INVESTMENT DECISIONS

Answer :

Advise to the Hospital Management

Determination of Cash inflows
Sales Revenue 40,000
Less: Operating Cost 7,500
32,500
Less: Depreciation (80,000 – 6,000)/8 9,250
Net Income 23,250
Tax @ 30% 6,975
Earnings after Tax (EAT) 16,275
Add: Depreciation 9,250
Cash inflow after tax per annum 25,525
Less: Loss of Commission Income 12,000
Net Cash inflow after tax per annum 13,525
In 8th Year :
New Cash inflow after tax 13,525
Add: Salvage Value of Machine 6,000
Net Cash inflow in year 8 19,525

Calculation of Net Present Value (NPV)

Year CFAT PV Factor @10% Present Value of Cash inflows

1 to 7 13,525 4.867 65,826.18
8 19,525 0.467 9,118.18
74,944.36
Less: Cash Outflows 80,000.00
NPV (5,055.64)

Advise: Since the net present value is negative and profitability index is also less than
1, therefore, the hospital should not purchase the diagnostic machine.
Note: Since the tax rate is not mentioned in the question, therefore, it is assumed to
be 30 percent in the given solution.

SANJAY SARAF SIR 382

CA INTER FINANCIAL MANAGEMENT

Question 29

The management of P Limited is considering selecting a machine out of two mutually

exclusive machines. The company’s cost of capital is 12 percent and corporate tax rate for
the company is 30 percent. Details of the machines are as follows:

Machine – I Machine – II
Cost of machine ` 10,00,000 ` 15,00,000
Expected life 5 years 6 years
Annual income before tax and depreciation ` 3,45,000 ` 4,55,000

Depreciation is to be charged on straight line basis.

You are required to:

i. Calculate the discounted pay-back period, net present value and internal rate of
return for each machine.
ii. Advise the management of P Limited as to which machine they should take up.
The present value factors of Re. 1 are as follows:

Year 1 2 3 4 5 6
At 12% .893 .797 .712 .636 .567 .507
At 13% .885 .783 .693 .613 .543 .480
At 14% .877 .769 .675 .592 .519 .456
At 15% .870 .756 .658 .572 .497 .432
At 16% .862 .743 .641 .552 .476 .410

SANJAY SARAF SIR 383

 INVESTMENT DECISIONS

Answer :

i. Computation of Discounted Payback Period, Net Present Value (NPV) and Internal
Rate of Return (IRR) for Two Machines
Calculation of Cash Inflows

Machine – I Machine – II
(` ) (` )
Annual Income before Tax and Depreciation 3,45,000 4,55,000
Less : Depreciation
Machine – I: 10,00,000 /5 2,00,000 -

Machine – II: 15,00,000 / 6 - 2,50,000

Income before Tax 1,45,000 2,05,000
Less: Tax @ 30 % 43,500 61,500
Income after Tax 1,01,500 1,43,500
Add: Depreciation 2,00,000 2,50,000
Annual Cash Inflows 3,01,500 3,93,500

Machine – I Machine – II
Year P.V. of Re.1 Cash flow P.V. Cumulative Cash P.V. Cumulative
@12% P.V flow P.V.

1 0.893 3,01,500 2,69,240 2,69,240 3,93,500 3,51,396 3,51,396

2 0.797 3,01,500 2,40,296 5,09,536 3,93,500 3,13,620 6,65,016
3 0.712 3,01,500 2,14,668 7,24,204 3,93,500 2,80,172 9,45,188
4 0.636 3,01,500 1,91,754 9,15,958 3,93,500 2,50,266 11,95,454
5 0.567 3,01,500 1,70,951 10,86,909 3,93,500 2,23,115 14,18,569
6 0.507 - - - 3,93,500 1,99,505 16,18,074

Discounted Payback Period for:

Machine – I
Discounted Payback Period 4 
10 , 000 , 000  9 ,15 , 958
1, 70 , 951
84 , 042
4  4  0.4916
1, 70 , 951
= 4.49 years or 4 years and 5.9 months

SANJAY SARAF SIR 384

CA INTER FINANCIAL MANAGEMENT

Machine – II

= 5.41 years or 5 years and 4.9 months

Net Present Value for:

Machine – I
NPV = ` 10,86,909 – 10,00,000 = ` 86,909

Machine – II
NPV = ` 16,18,074 – 15,00,000 = ` 1,80,074

Internal Rate of Return (IRR) for:

Machine – I

PV factor falls between 15% and 16%

Present Value of Cash inflow at 15% and 16% will be:
Present Value at 15% = 3.353 x 3,01,500 = 10,10,930
Present Value at 16% = 3.274 x 3,01,500 = 9,87,111

Machine - II
15 , 00 , 000
P.V. Factor   3.8119
3, 93, 500
Present Value of Cash inflow at 14% and 15% will be:
Present Value at 14% = 3.888 x 3,93,500 = 15,29,928
Present Value at 15% = 3.785 x 3,93,500 = 14,89,398

SANJAY SARAF SIR 385

 INVESTMENT DECISIONS

ii. Advise to the Management

Ranking of Machines in terms of the Three Methods

Machine - I Machine - II
Discounted Payback Period I II
Net Present Value II I
Internal Rate of Return I II

Advise: Since Machine - I has better ranking than Machine – II, therefore, Machine
– I should be selected.

Question 30

ANP Ltd. is providing the following information:

Annual cost of saving ` 96,000
Useful life 5 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.05

Table of discount factor:

Years
Discount factor
1 2 3 4 5 Total
15% 0.870 0.756 0.658 0.572 0.497 3.353
14% 0.877 0.769 0.675 0.592 0.519 3.432
13% 0.886 0.783 0.693 0.614 0.544 3.52

You are required to calculate:

i. Cost of the project
ii. Payback period
iii. Net present value of cash inflow
iv. Cost of capital.

Answer :
i. Cost of Project
At 15% internal rate of return (IRR), the sum of total cash inflows = cost of the project
i.e initial cash outlay
Annual cost savings = ` 96,000
Useful life = 5 years

SANJAY SARAF SIR 386

CA INTER FINANCIAL MANAGEMENT

Considering the discount factor table @ 15%, cumulative present value of cash
inflows for 5 years is 3.353
Hence, Total Cash inflows for 5 years for the Project is
96,000 x 3.353 = ` 3,21,888
Hence, Cost of the Project = ` 3,21,888

ii. Payback Period

Payback Period = 3.353 years

iii. Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ` 3,37,982.40 – 3,21,888 = ` 16,094.40
Net Present Value = ` 16,094.40

iv. Cost of Capital

∴ Sum of Discounted Cash inflows = ` 3,37,982.40

`3, 37 , 982.40
Hence, cumulative discount factor for 5 years 
96 , 000
From the discount factor table, at discount rate of 13%, the cumulative discount factor
for 5 years is 3.52
Hence, Cost of Capital = 13%

Question 31

SS Limited is considering the purchase of a new automatic machine which will carry out
some operations which are at present performed by manual labour. NM-A1 and NM-A2,
two alternative models are available in the market. The following details are collected :

SANJAY SARAF SIR 387

 INVESTMENT DECISIONS

Machine
NM-A1 NM-A2
Cost of Machine (`) 20,00,000 25,00,000
Estimated working life 5 Years 5 Years
Estimated saving in direct wages per annum (`) 7,00,000 9,00,000
Estimated saving in scrap per annum (`) 60,000 1,00,000
Estimated additional cost of indirect material per annum (`) 30,000 90,000
Estimated additional cost of indirect labour per annum (`) 40,000 50,000
Estimated additional cost of repairs and maintenanceper annum (`) 45,000 85,000

Depreciation will be charged on a straight line method. Corporate tax rate is 30

percent and expected rate of return may be 12 percent.
You are required to evaluate the alternatives by calculating the:
(i) Pay-back Period
(ii) Accounting (Average) Rate of Return; and
(iii) Profitability Index or P.V. Index (P.V. factor for ` 1 @ 12% 0.893; 0.797; 0.712;
0.636; 0.567 0.507)

Answer :

Evaluation of Alternatives

Working Notes:

20 , 00 , 000
Depreciation on Machine NM-A1 
5

= 4,00,000

25 , 00 , 000
Depreciation on Machine NM-A2 =   5 , 00 , 000
5

SANJAY SARAF SIR 388

CA INTER FINANCIAL MANAGEMENT

Particulars Machine NM-A1 (`) Machine NM-A2 (`)

Annual Savings:
Direct Wages 7,00,000 9,00,000
Scraps 60,000 1,00,000
Total Savings (A) 7,60,000 10,00,000
Annual Estimated Cash Cost :
Indirect Material 30,000 90,000
Indirect Labour 40,000 50,000
Repairs and Maintenance 45,000 85,000
Total Cost (B) 1,15,000 2,25,000
Annual Cash Savings (A-B) 6,45,000 7,75,000
Less: Depreciation 4,00,000 5,00,000
Annual Savings before Tax 2,45,000 2,75,000
Less: Tax @ 30% 73,500 82,500
Annual Savings /Profits after tax 1,71,500 1,92,500
Add: Depreciation 4,00,000 5,00,000
Annual Cash Inflows 5,71,500 6,92,500

(i) Payback Period

Total Initial Capital Investment
Machine NM – A1 
Annual exp ected after tax net cashflow
20 , 00 , 000
  3.50 years
5 , 71, 500
25 , 00 , 000
Machine NM – A2 =   3.61 years
6 , 92 , 500
Decision: Machine NM-A1 is better.

(ii) Accounting (Average) Rate of Return (ARR)

Average Annual Net Savings
ARR   100
Average Investment
1, 71, 500
Machine NM – A1 = . %
 100  1715
10 , 00 , 000
1, 92 , 500
Machine NM – A2 =  100  15.4%
10 , 00 , 000
Decision: Machine NM-A1 is better

SANJAY SARAF SIR 389

 INVESTMENT DECISIONS

(Note: ARR may be computed alternatively by taking initial investment in the

denominator.)

(iii) Profitability Index or PV Index

Present Value Cash Inflow = Annual Cash Inflow x PV factor at 12%
Machine NM-A1 = 5, 71,500 x 3.605 = ` 20, 60,258
Machine NM-A2 = 6, 92,500 x 3.605 = ` 24, 96,463
Present Value of Cash Inflow
PV Index =
Investment
20 , 60 , 258
Machine NM-A1 =  1.03
20 , 00 , 000
24 , 96 , 463
Machine NM-A2 =  0.998  1.0 approx
25 , 00 , 000
Decision: Machine NM-A1 is better.

Question 32

PQR Company Ltd. Is considering to select a machine out of two mutually exclusive
machines. The company’s cost of capital is 12 per cent and corporate tax rate is 30
per cent. Other information relating to both machines is as follows:

Machine – I Machine – II
Cost of Machine ` 15,00,000 ` 20,00,000
Expected Life 5 Yrs. 5 Yrs.
Annual Income (Before Tax and Depreciation) ` 6,25,000 ` 8,75,000

Depreciation is to be charged on straight line basis:

You are required to calculate:

(i) Discounted Pay Back Period
(ii) Net Present Value
(iii) Profitability Index

The present value factors of ` 1 @ 12% are as follows:

Year 01 02 03 04 05
PV factor @ 12% 0.893 0.797 0.712 0.636 0.567

SANJAY SARAF SIR 390

CA INTER FINANCIAL MANAGEMENT

Answer :

Working Notes:
15 , 00 , 000
Depreciation on Machine – I  ` 3, 00 , 000
5
20 , 00 , 000
Depreciation on Machine – II  ` 4 , 00 , 000
5

Particulars Machine-I (`) Machine – II (`)

Annual Income (before Tax and Depreciation) 6,25,000 8,75,000
Less: Depreciation 3,00,000 4,00,000
Annual Income (before Tax) 3,25,000 4,75,000
Less: Tax @ 30% 97,500 1,42,500
Annual Income (after Tax) 2,27,500 3,32,500
Add: Depreciation 3,00,000 4,00,000
Annual Cash Inflows 5,27,500 7,32,500

Machine – I Machine - II
Year PV of Re 1 Cash PV Cumulative Cash PV Cumulative
@ 12% flow PV flow PV
1 0.893 5,27,500 4,71,058 4,71,058 7,32,500 6,54,123 6,54,123
2 0.797 5,27,500 4,20,418 8,91,476 7,32,500 5,83,803 12,37,926
3 0.712 5,27,500 3,75,580 12,67,056 7,32,500 5,21,540 17,59,466
4 0.636 5,27,500 3,35,490 16,02,546 7,32,500 4,65,870 22,25,336
5 0.567 5,27,500 2,99,093 19,01,639 7,32,500 4,15,328 26,40,664

(i) Discounted Payback Period

Machine - I

Discounted Payback Period = 3 

15 , 00 , 000  2 , 67 , 056
3 , 35 , 490
2 , 32 , 944
= 3
3, 35 , 490
= 3 + 0.6943
= 3. 69 years or 3 years 8.28 months

SANJAY SARAF SIR 391

 INVESTMENT DECISIONS

Machine II

Discounted Payback Period = 3 

 20 , 00 , 000  17 , 59 , 466
4 , 65 , 870
2 , 40 , 534
= 3  3  0.5163
4 , 65 , 870
= 3.52 years or 3 years 6.24 months
(ii) Net Present Value (NPV)

Machine I
19 , 01, 639
Profitability Index   1.268
15 , 00 , 000
Machine - II
26 , 40 , 664
Profitability Index   1.320
20 , 00 , 000
Conclusion:
Method Machine - I Machine - II Rank
Discounted Payback Period 3.69 years 3.52 years II
Net Present Value `4,01,639 `6,40,664 II
Profitability Index 1.268 1.320 II

Question 33

APZ Limited is considering to select a machine between two machines 'A' and 'B'.
The two machines have identical capacity, do exactly the same job, but designed
differently.
Machine 'A' costs ` 8,00,000, having useful life of three years. It costs ` 1,30,000 per year to
run.
Machine 'B' is an economy model costing ` 6,00,000, having useful life of two years. It costs
` 2,50,000 per year to run.
The cash flows of machine 'A' and 'B' are real cash flows. The costs are forecasted in rupees
of constant purchasing power. Ignore taxes.
The opportunity cost of capital is 10%.
The present value factors at 10% are :
Year t1 t2 t3
PVIF0.10,t 0.9091 0.8264 0.7513
PVIFA0.10,2 = 1.7355
PVIFA0.10,3 = 2.4868

Which machine would you recommend the company to buy?

SANJAY SARAF SIR 392
CA INTER FINANCIAL MANAGEMENT

Answer :

Statement Showing Evaluation of Two Machines

Particulars Machine A Machine B

Purchase Cost (`) : (i) 8,00,000 6,00,000
Life of Machines (in years) 3 2
Running Cost of Machine per year (`) : (ii) 1,30,000 2,50,000
Cumulative PVF for 1-3 years @ 10% : (iii) 2.4868 -
Cumulative PVF for 1-2 years @ 10% : (iv) - 1.7355
Present Value of Running Cost of Machines (`): 3,23,284 4,33,875
(v) = [(ii) x (iii)]
Cash Outflow of Machines (`) : (vi) = (i) + (v) 11,23,284 10,33,875
Equivalent Present Value of Annual Cash Outflow 4,51,698.57 5,95,721.69
[(vi) ÷ (iii)] Or 4,51,699 Or 5,95,722

Recommendation: APZ Limited should consider buying Machine A since its equivalent
Cash outflow is less than Machine B.

Question 34

FH Hospital is considering to purchase a CT-Scan machine. Presently the hospital is

outsourcing the CT -Scan Machine and is earning commission of ` 15,000 per month (net of
tax). The following details are given regarding the machine:

`
Cost of CT -Scan machine 15,00,000
Operating cost per annum (excluding Depreciation) 2,25,000
Expected revenue per annum 7,90,000
Salvage value of the machine (after 5 years) 3,00,000
Expected life of the machine 5 years

Assuming tax rate @ 30%, whether it would be profitable for the hospital to
purchase the machine?
Give your recommendation under:
(i) Net Present Value Method, and
(ii) Profitability Index Method.

SANJAY SARAF SIR 393

 INVESTMENT DECISIONS

PV factors at 12% are given below:

Year 1 2 3 4 5
PV factor 0.893 0.797 0.712 0.636 0.567
Source : ICAI, Compilation (Old)
Answer :

Advise to the Hospital Management

Determination of Cash inflows `
Sales Revenue 7,90,000
Less: Operating Cost 2,25,000
5,65,000
Less: Depreciation (15,00,000 – 3,00,000)/5 2,40,000
Net Income 3,25,000
Tax @ 30% 97,500
Earnings after Tax (EAT) 2,27,500
Add: Depreciation 2,40,000
Cash inflow after tax per annum 4,67,500
Less: Loss of Commission Income 1,80,000
Net Cash inflow after tax per annum 2,87,500
In 5th Year :
New Cash inflow after tax 2,87,500
Add: Salvage Value of Machine 3,00,000
Net Cash inflow in year 5 5,87,500
Calculation of Net Present Value (NPV)

Year CFAT PV Factor Present Value of Cash inflows

@10%
1 to 4 2,87,500 3.038 8,73,425.00
5 5,87,500 0.567 3,33,112.50
12,06,537.50
Less: Cash Outflows 15,00,000.00
NPV (2,93,462.50)

Sum of discounted cash inf lows 12 , 06 , 537.50

Pr ofitability Index    0.804
Pr esent value of cash outflows 15 , 00 , 000

Advise: Since the net present value is negative and profitability index is also less than 1,
therefore, the hospital should not purchase the CT-Scan machine.

SANJAY SARAF SIR 394

CA INTER FINANCIAL MANAGEMENT

 OTHER PROBLEMS

Question 1

An enterprise is investing Rs.100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the management is 7%. The life of the project is 5 years. Following
are the cash flows that are estimated over the life of the project.

Year Cash flows (Rs.)

1 25,00,000
2 60,00,000
3 75,00,000
4 80,00,000
5 65,00,000

Calculate Net Present Value of the project based on Risk free rate and also on the basis of
Risks adjusted discount rate.
Source : ICAI, MTP I (New)
Answer :

The Present Value of the Cash Flows for all the years by discounting the cash flow
at 7% is calculated as below:

When the risk-free rate is 7% and the risk premium expected by the management is 7 %. So
the risk adjusted discount rate is 7% + 7% =14%.

SANJAY SARAF SIR 395

 INVESTMENT DECISIONS

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as
below:

Question 2

X Limited is considering to purchase of new plant worth Rs. 80,00,000. The expected net
cash flows after taxes and before depreciation are as follows:

The rate of cost of capital is 10%.

You are required to Calculate

(i) Pay-back period
(ii) Net present value at 10 discount factor
(iii) Profitability index at 10 discount factor
(iv) Internal rate of return with the help of 10% and 15% discount factor

SANJAY SARAF SIR 396

CA INTER FINANCIAL MANAGEMENT

The following present value table is given for you:

Source : ICAI, MTP II (New)

Answer :

(i) Calculation of Pay-back Period

Cash Outlay of the Project = Rs. 80,00,000
Total Cash Inflow for the first five years = Rs. 70,00,000
Balance of cash outlay left to be paid back in the 6th year Rs. 10,00,000
Cash inflow for 6th year = 16,00,000
So the payback period is between 5th and 6th years, i.e.,
Rs.10 , 00 , 000
5 years   5.625 years or 5 years 7.5 months
Rs. 6 , 00 , 000

(ii) Calculation of Net Present Value (NPV) @10% discount rate:

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Net Present Value (NPV) = Cash Outflow – Present Value of Cash Inflows
= Rs. 80,00,000 – Rs. 97,92,200 = 17,92,200

(iii) Calculation of Profitability Index @ 10% discount rate:

Rs. 97 , 92 , 200
  1.224
Rs. 80 , 00 , 000

(iv) Calculation of Internal Rate of Return:

Net present value @ 10% interest rate factor has already been calculated in (ii)
above, we will calculate Net present value @15% rate factor.

Net Present Value at 15% = Rs. 78,84,000 – Rs. 80,00,000 = Rs. -1,16,000
As the net present value @ 15% discount rate is negative, hence internal rate of
return falls in between 10% and 15%. The correct internal rate of return can be
calculated as follows:
NPVL
IRR  L   H  L
NPVL  NPVH
Rs. 17 , 92 , 200
 10%  15%  10%
Rs.17 , 92 , 200   Rs.1,16 , 000 
Rs. 17 , 92 , 200
 10%   5%  14.7%
Rs.19 , 08 , 200

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Question 3

XYZ Ltd. is presently all equity financed. The directors of the company have been
evaluating investment in a project which will require ` 270 lakhs capital expenditure
on new machinery. They expect the capital investment to provide annual cash flows of ` 42
lakhs indefinitely which is net of all tax adjustments. The discount rate which it applies to
such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take
advantage of tax benefits of debt, and propose to finance the new project with
undated perpetual debt secured on the company's assets. The company intends to issue
sufficient debt to cover the cost of capital expenditure and the after tax cost of issue.
The current annual gross rate of interest required by the market on corporate
undated debt of similar risk is 10%. The after tax costs of issue are expected to be `
10 lakhs. Company's tax rate is 30%.

You are required to calculate:

(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be used to
evaluate future investments.
Source : ICAI, May 2018 Question Paper
Answer :

(i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV = Base Case PV + PV of financing decisions associated with the
project
Base Case NPV for the project:
(-) ` 270 lakhs + (` 42 lakhs / 0.14) = (-) ` 270 lakhs + ` 300 lakhs
= ` 30
Issue costs = ` 10 lakhs
Thus, the amount to be raised = ` 270 lakhs + ` 10 lakhs
= ` 280 lakhs
Annual tax relief on interest payment = ` 280 X 0.1 X 0.3
= ` 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ` 8.4 lakhs / 0.1
= ` 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= ` 30 lakhs – ` 10 lakhs + 84 lakhs = ` 104 lakhs

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(ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) `280 lakhs X (Annual Income / 0.14) = (-) `104 lakhs
Annual Income / 0.14 = (-) ` 104 + ` 280 lakhs
Therefore, Annual income = ` 176 X 0.14 = ` 24.64 lakhs
Adjusted discount rate = (` 24.64 lakhs / `280 lakhs) X 100
= 8.8%

(iii) Useable circumstances

This ADR may be used to evaluate future investments only if the business risk
of the new venture is identical to the one being evaluated here and the project is to be
financed by the same method on the same terms. The effect on the company’s cost of
capital of introducing debt into the capital structure cannot be ignored.

Question 4

A company is evaluating a project that requires initial investment of ` 60 lakhs in fixed

assets and ` 12 lakhs towards additional working capital.
The project is expected to increase annual real cash inflow before taxes by
` 24,00,000 during its life. The fixed assets would have zero residual value at the end
of life of 5 years. The company follows straight line method of depreciation which is
expected for tax purposes also. Inflation is expected to be 6% per year. For evaluating
similar projects, the company uses discounting rate of 12% in real terms. Company's tax
rate is 30%.
Advise whether the company should accept the project, by calculating NPV in real terms.

Source : ICAI, May 2018 Question Paper

Answer :

(i) Equipment’s initial cost = ` 60,00,000 + ` 12,00,000

= ` 72,00,000
(ii) Annual straight line depreciation = ` 60,00,000/5
= ` 12,00,000.

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(iii) Net Annual cash flows can be calculated as follows:

= Before Tax CFs × (1 – Tc) + Tc × Depreciation (Tc = Corporate tax i.e. 30%)
= ` 24,00,000 × (1 – 0.3) + (0.3 x ` 12,00,000)
= ` 16,80,000 + ` 3,60,000 = ` 20,40,000
So, Total Present Value = PV of inflow + PV of working capital released
= (` 20,40,000 × PVIF 12%, 5 years) + (` 12,00,000 × 0.567)
= (` 20,40,000 × 3.605) + ` 6,80,400
= ` 73,54,200 + ` 6,80,400
= ` 80,34,600
So NPV = PV of Inflows – Initial Cost
= ` 80,34,600 – ` 72,00,000
= ` 8,34,600
Advice: Company should accept the project as the NPV is Positive.

Question 5

Beta Limited receives ` 15,00,000 a year after taxes from an investment in an automatic
plant that has 12 more years of service life. The company’s required rate is 12%. Beta
Limited can make improvements to the plant to raise its service life to 20 years and its
annual after tax cash flow to ` 48,00,000 per year. These investments would cost `
2,10,00,000. With the improvements, the plant’s value at the end of 12 years would rise
from `7,50,000 to `75,00,000. Would the improvements produce a return satisfactory to Beta
Limited?
Source : ICAI, RTP November 2013 (Old)
Answer :

Calculation of the Present value of the inflows before improvements to the automatic
plant

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Calculation of the Present value of the inflows after improvement to the automatic
plant

Differential Present value of the inflow after improvements to the automatic plant
= ` 3,16,58,700 (B) – ` 94,83,750 (A)
= ` 2,21,74,950
Net Present value from the investments in the automatic plant
= P.V. of Cash Inflow – Cash Outflow
= ` 2,21,74,950 – ` 2,10,00,000
= ` 11,74,950
Advise: Since the NPV is positive, the improvements produce a satisfactory return to the
firm.

Question 6

A machine purchased six years back for `1,50,000 has been depreciated to a book value of
`90,000. It originally had a projected life of fifteen years and zero salvage value. A
new machine will cost `2,50,000 and result in a reduced operating cost of `30,000 per year
for the next nine years. The older machine could be sold for `50,000. The new
machine shall also be depreciated on a straight-line method on nine-year life with
salvage value of `25,000. The company's tax rate is 50% and cost of capital is 10%.
Determine whether the old machine should be replaced.
Given: Present Value of Re. 1 at 10% on 9th year = 0.424; and Present Value of an
annuity of Re. 1 at 10% for 8 years = 5.335.
Source : ICAI, RTP November 2013 (Old)
Answer :
Cash outflow
`
Cost of new machine 2,50,000.00
Less: Sale of old machine 50,000.00
Less: Tax saving from loss due to sale of old machine `40,000 20,000.00
(` 90,000 – ` 50,000) × 50%
Net Cash Outflow 1,80,000.00

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Cash inflow

Determination of Net Present Value

Decision: Since the net present value is negative, the old machine should not be
replaced.

Question 7

Gamma Limited is considering building an assembly plant and the company has two
options, out of which it wishes to choose the best plant. The projected output is 10,000 units
per month. The following data is available:

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Both the plants have an expected life of 10 years after which there will be no
salvage value. The cost of capital is 10 percent. The present value of an ordinary annuity of
Re. 1 for 10 years @ 10 percent is 6.1446. Ignore effect of taxation.
You are required to determine:
a. What would be the desirable choice?
b. What other important elements are to be considered before the final decision is
taken?
Source : ICAI, RTP May 2014(Old)
Answer :

a. Computation of Differential Cash Flow

Present value of net saving of (` 3,20,000 × 6.1446) = ` 19,66,272 for Plant A @

10% (cost of capital).

b. Additional Cash Outlay for Plant A over Plant B

Analysis : The net saving for the company in choosing Plant A = ` 19,66,272 –
` 16,00,000 = ` 3,66,272. Hence, Plant A should be implemented.

Question 8

Fibroplast Limited, a toy manufacturing company, is considering replacing an older

machine which was fully depreciated for tax purposes with a new machine costing `
40,000. The new machine will be depreciated over its eight-year life. It is estimated that the
new machine will reduce labour costs by ` 8,000 per year. The management believes that
there will be no change in other expenses and revenues of the firm due to the
machine. The company requires an after-tax return on investment of 10 per cent. Its rate of

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tax is 35 per cent. The company’s income statement for the current year is given for other
information.
Income statement for the current year:

Should the Fibroplast Limited buy the new machine? You may assume the
company follows straight-line method of depreciation and the same is allowed for tax
purposes.
Source : ICAI, RTP May 2014(Old)
Answer :
Cash Inflows

Advise: Since the NPV is negative, the new machine should not be purchased.

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 THEORETICAL QUESTIONS

Source : ICAI, PM (Old) - (From Question No. 1 - 9 )

Question 1

Do the profitability index and the NPV criterion of evaluating investment proposals lead
to the same acceptance-rejection and ranking decisions? In what situations will they give
conflicting results?

Answer :

In the most of the situations the Net Present Value Method (NPV) and Profitability Index
(PI) yield same accept or reject decision. In general items, under PI method a project is
acceptable if profitability index value is greater than 1 and rejected if it less than 1. Under
NPV method a project is acceptable if Net present value of a project is positive and rejected
if it is negative. Clearly a project offering a profitability index greater than 1 must also offer
a net present value which is positive. But a conflict may arise between two methods if a
choice between mutually exclusive projects has to be made. Consider the following
example:

Project A Project B
PV of Cash inflows 2,00,000 1,00,000
Initial cash outflows 1,00,000 40,000
Net present value 1,00,000 60,000
P.I 2 , 00 , 000 1, 00 , 000
2  2.5
1, 00 , 000 40 , 000

According to NPV method, project A would be preferred, whereas according to

profitability index method project B would be preferred.
This is because Net present value gives ranking on the basis of absolute value of
rupees, whereas, profitability index gives ranking on the basis of ratio. Although PI method
is based on NPV, it is a better evaluation technique than NPV in a situation of capital
rationing.

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Question 2

Distinguish between Net Present Value and Internal Rate of Return.

Answer :

NPV versus IRR : NPV and IRR methods differ in the sense that the results regarding the
choice of an asset under certain circumstances are mutually contradictory under two
methods. In case of mutually exclusive investment projects, in certain situations, they
may give contradictory results such that if the NPV method finds one proposal acceptable,
IRR favours another. The different rankings given by the NPV and IRR methods could be
due to size disparity problem, time disparity problem and unequal expected lives.
The net present value is expressed in financial values whereas internal rate of return (IRR)
is expressed in percentage terms.
In the net present value cash flows are assumed to be re-invested at cost of capital rate. In
IRR reinvestment is assumed to be made at IRR rates.

Question 3

Write a short note on internal rate of return.

Answer :

Internal Rate of Return: It is that rate at which discounted cash inflows are equal to the
discounted cash outflows. In other words, it is the rate which discounts the cash flows to
zero. It can be stated in the form of a ratio as follows:
Cash inflows
1
Cash Outflows
This rate is to be found by trial and error method. This rate is used in the evaluation of
investment proposals. In this method, the discount rate is not known but the cash outflows
and cash inflows are known.
In evaluating investment proposals, internal rate of return is compared with a required rate
of return, known as cut-off rate. If it is more than cut-off rate the project is treated as
acceptable; otherwise project is rejected.

Question 4

What do you understand by desirability factor/profitability index?

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Answer :

Desirability Factor/Profitability Index

In certain cases we have to compare a number of proposals each involving different amount
of cash inflows. One of the methods of comparing such proposals is to work out what is
known as the ‘Desirability factor’ or ‘Profitability index’. In general terms, a project is
acceptable if its profitability index value is greater than 1.
Mathematically, the desirability factor is calculated as below:
Sum of Discounted Cash inflows
Initial Cash outlay or Total Discounted Cash outflow (as the case may be)

Question 5

Write a short note on “Cut - off Rate”.

Answer :

Cut - off Rate: It is the minimum rate which the management wishes to have from any
project. Usually this is based upon the cost of capital. The management gains only if a
project gives return of more than the cut - off rate. Therefore, the cut - off rate can be used
as the discount rate or the opportunity cost rate.

Question 6

Define Modified Internal Rate of Return method.

Answer :

Modified Internal Rate of Return (MIRR): There are several limitations attached with
the concept of the conventional Internal Rate of Return. The MIRR addresses some of
these deficiencies. For example, it eliminates multiple IRR rates; it addresses the
reinvestment rate issue and produces results, which are consistent with the Net Present
Value method.
Under this method, all cash flows, apart from the initial investment, are brought to the
terminal value using an appropriate discount rate (usually the cost of capital). This results
in a single stream of cash inflow in the terminal year. The MIRR is obtained by assuming a
single outflow in the zeroth year and the terminal cash inflow as mentioned above. The
discount rate which equates the present value of the terminal cash in flow to the zeroth year
outflow is called the MIRR.

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Question 7

Explain the concept of Multiple Internal Rate of Return.

Answer :

Multiple Internal Rate of Return (MIRR)

In cases where project cash flows change signs or reverse during the life of a project for
example, an initial cash outflow is followed by cash inflows and subsequently followed
by a major cash outflow; there may be more than one internal rate of return (IRR). The
following graph of discount rate versus net present value (NPV) may be used as an
illustration:

In such situations if the cost of capital is less than the two IRRs, a decision can be made
easily, however, otherwise the IRR decision rule may turn out to be misleading as the
project should only be invested if the cost of capital is between IRR 1 and IRR2. To
understand the concept of multiple IRRs it is necessary to understand the implicit re-
investment assumption in both NPV and IRR techniques.

Question 8

Explain the concept of discounted payback period.

Answer :

Concept of Discounted Payback Period

Payback period is time taken to recover the original investment from project cash flows. It
is also termed as break even period. The focus of the analysis is on liquidity aspect and it

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suffers from the limitation of ignoring time value of money and profitability.
Discounted payback period considers present value of cash flows, discounted at
company’s cost of capital to estimate breakeven period i.e. it is that period in which future
discounted cash flows equal the initial outflow. The shorter the period, better it is. It also
ignores post discounted payback period cash flows.

Question 9

Distinguish between Net Present Value (NPV) and Internal Rate of Return (IRR)
methods for evaluating projects.

Answer :

Distinguish between Net Present Value (NPV) and Internal Rate of Return (IRR)
NPV and IRR methods differ in the sense that the results regarding the choice of an asset
under certain circumstances are mutually contradictory under two methods. In case
of mutually certain circumstances are mutually contradictory under two methods. In
case of mutually exclusive investment projects, in certain situations, they may give
contradictory results such that if the NPV method finds one proposal acceptable, IRR
favours another. The different rankings given by the NPV and IRR methods could be
due to size disparity problem, time disparity problem and unequal expected lives.
The net present value is expressed in financial values whereas internal rate of return (IRR)
is expressed in percentage terms.
In the net present value cash flows are assumed to be re-invested at cost of capital rate. In
IRR reinvestment is assumed to be made at IRR rates.

Question 10

What are the limitations of ARR method of capital budgeting technique.

Source : ICAI, MTP I (Old)
Answer :

Limitations of ARR
The accounting rate of return technique, like the payback period technique, ignores the
time value of money and considers the value of all cash flows to be equal.
The technique uses accounting numbers that are dependent on the organization’s
choice of accounting procedures, and different accounting procedures, e.g., depreciation
methods, can lead to substantially different amounts for an investment’s net income and
book values.

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The method uses net income rather than cash flows; while net income is a useful measure
of profitability, the net cash flow is a better measure of an investment’s performance.
Furthermore, inclusion of only the book value of the invested asset ignores the fact that a
project can require commitments of working capital and other outlays that are not
included in the book value of the project.

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Chapter
RISK ANALYSIS IN CAPITAL
8 BUDGETING

LEARNING OUTCOMES
 Discuss the concept of Risk and Uncertainty in Capital Budgeting.
 Discuss the Sources of Risk.
 Understand reasons for adjusting risk in Capital Budgeting.
 Understand various techniques used in Risk Analysis in Capital Budgeting.
 Discuss Concepts, Advantages and Limitations of various techniques of Risk
analysis in Capital Budgeting.

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CHAPTER OVERVIEW

Techniques of Risk analysis in Capital Budgeting

Statistical Conventional Other

Techniques Techniques Techniques

1. Probability 1. Risk-adjusted 1. Sensitivity

2. Variance or discount rate Analysis
Standard 2. Certainty 2. Scenario
deviation equivalents Analysis
3. Coefficient of 3. Simulation
Variation 4. Decision Tree

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SUMMARY

 Risk : Risk denotes variability of possible outcomes from what was expected.
Standard Deviation is perhaps the most commonly used tool to measure risk. It
measures the dispersion around the mean of some possible outcome.
 Risk Adjusted Discount Rate Method : The use of risk adjusted discount rate is
based on the concept that investors demands higher returns from the risky projects.
The required return of return on any investment should include compensation for
delaying consumption equal to risk free rate of return, plus compensation for any
kind of risk taken on.
 Certainty Equivalent Approach : This approach allows the decision maker to
incorporate his or her utility function into the analysis. In this approach a set of risk
less cash flow is generated in place of the original cash flows.
 Sensitivity Analysis: Also known as “What if” Analysis. This analysis determines
how the distribution of possible NPV or internal rate of return for a project under
consideration is affected consequent to a change in one particular input variable.
This is done by changing one variable at one time, while keeping other variables
(factors) unchanged.
 Scenario Analysis : Although sensitivity analysis is probably the most widely used
risk analysis technique, it does have limitations. Therefore, we need to extend
sensitivity analysis to deal with the probability distributions of the inputs. In
addition, it would be useful to vary more than one variable at a time so we could see
the combined effects of changes in the variables.
 Simulation Analysis (Monte Carlo) : Monte Carlo simulation ties together
sensitivities and probability distributions. The method came out of the work of
first nuclear bomb and was so named because it was based on mathematics of
Casino gambling. Fundamental appeal of this analysis is that it provides decision
makers with a probability distribution of NPVs rather than a single point estimates
of the expected NPV. Following are main steps in simulation analysis:
 Decision Trees : By drawing a decision tree, the alternations available to an
investment decision are highlighted through a diagram, giving the range of
possible outcomes.

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PRACTICAL PROBLEMS

 MULTIPLE CHOICE QUESTIONS

1. Project Analysis can be done using:

a. Sensitivity Analysis
b. Scenario Analysis
c. Monte Carlo Simulation
d. All of the Above

2. Which from the following is not a part of Monte Carlo Simulation

a. Modeling the Project
b. Simulating Results
c. Calculating NPV
d. Specifying Probabilities

3. Variance Measures
a. How far each number in the set is from the mean
b. The mean of a given data set
c. Return on Investment
d. level of risk borne for every percent of expected return

4. Certainty Equivalent
a. Is a guaranteed return from an Investment after adjusting for risk
b. Is the return that is expected over the lifetime of a project
c. Is equivalent to Net Present Value
d. Is an important component in Decision Tree Analysis

5. For a project, where the cash flows are ` 90,00,000, rate of return is 15% , risk free rate
is 4 %and risk premium is 9%, the Certainty Equivalent is
a. 78,26, 087
b. 86,53,846
c. 82,56, 881
d. 81,08,108

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6. Risk Premium
a. is the extra rate of return expected by the Investors as a reward for bearing extra
risk
b. is equivalent to the rate of Government Securities
c. is the return provided to equity shareholders
d. is over and above expected rate of return

7. In Decision Tree Analysis, the Problem / decision is the

a. Decision Node
b. Root Node
c. Event Node
d. End Node

8. Scenario Analysis is considered under scenarios such as

a. Worst Case Scenario
b. Base Case Scenario
c. Best Case Scenario
d. All of the above

9. Sensitivity analysis is useful in decision making because

a. It shows the probabilities associated with each outcome
b. It tells the user how much critical each input is for the Output value
c. It allows to calculate the probable results under different scenarios
d. The results of Sensitivity Analysis are reliable

10. Monte Carlo Simulation involves

a. Identification of key variables on which outcome of the experiment would
depend.
b. Fixing of the range of values within which the results are expected to vary
c. Assigning Probability Distribution after a large number of random samples is
performed.
d. All of the above

ANSWERS

1. d 2. c

3. a 4. a
5. d 6. a
7. b 8. d
9. b 10. d

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 ILLUSTRATIONS

Source : ICAI, SM (New) - (From Question No. 1 - 12 )

Question 1

Possible net cash flows of Projects A and B and their probabilities are given as below.
Discount rate is 10 per cent for both the project initially investment is ` 10,000. Calculate the
expected net present value for each project. Which project is preferable?

Project A Project B
Possible Cash Flow
Probability Cash Flow (`) Probability
Event (`)
A 8,000 0.10 4,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,0,000 0.10

Answer :

Calculation of Expected Value for Project A and Project B

Project A Project B
Net Cash Expected Cash Expected
Possible
Flow Probability Value Flow Probability Value
Event
(`) (`) (`) (`)
A 8,000 0.10 800 4,000 0.10 400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 80,000 0.10 800
ENCF 12,000 16,000

The net present value for Project A is (0.909 × ` 12,000 – ` 10,000) = ` 908
The net present value for Project B is (0.909 × ` 16,000 – `10,000) = ` 4,544.

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Question 2

Probabilities for net cash flows for 3 years a project are as follows:
Year 1 Year 2 Year 3
Cash Flow Probability Cash Flow Probability Cash Flow Probability
(`) (`) (`)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1

Calculate the expected net cash flows. Also calculate the present value of the expected cash
flow, using 10 per cent discount rate. Initial Investment is ` 10,000.

Answer :

Year 1 Year 2 Year 3

Cash Probability Expected Cash Probability Expected Cash Probability Expected
Flow Value Flow Value Flow Value
(`) (`) (`) (`) (`) (`)
2,000 0.1 200 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
ENCF 6,000 4,800 4,200

The present value of the expected value of cash flow at 10 per cent discount rate has been
determined as follows:
ENCF1 ENCF2 ENCF3
Present Value of cash flow :  
( 1+ K) ( 1+ K) ( 1+ K)3
1 2

6, 000 4,800 4, 200

=  
1.1 1.1 1.1
2 2 3

= (6,000 × 0.909) + (4,800 × 0.826) + (4,200 + 0.751) = 12,573

Expected Net Present value = Present Value of cash flow - Initial Investment
= ` 12,573 – `10,000 = `2,573.

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Question 3

Calculate Variance and Standard Deviation on the basis of figure given in question 1.

Answer :

Project A :

Variance(σ2) =(8,000 – 12,000)2 (0.1)+ (10,000 -12,000)2 (0.2) + (12,000 – 12000)2 (0.4) + (14,000
– 12,000)2 (0.2) + (16000 – 12,000)2 (0.1) = 48,00,000

Standard Deviation(σ) = 48,00,000  2190.90

Project B :

Variance(σ2) = (24,000 – 16,000)2 (0.1) + (20,000 – 16,000)2 (0.15) + (16,000 – 16,000)2 (0.5) +
(12,000 – 16,000)2 (0.15) + (8,000 – 16,000)2 (0.1) = 44,00,000

Standard Deviation (σ) = 76,00,000 = 4195.23

Question 4

Calculate Coefficient of Variation based on the figure of question 1 and question 3

Answer :

Projects Coefficient of variation Risk Expected Value

2190.90
A  0.1826 Less Less
12,000
4195.23
B  0.2622 More More
16,000

SANJAY SARAF SIR 419

 RISK ANALYSIS IN CAPITAL BUDGETING

Question 5

An enterprise is investing ` 100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following
are the cash flows that are estimated over the life of the project.

Year Cash flows (` in lakhs)

1 25
2 60
3 75
4 80
5 65

Calculate Net Present Value of the project based on Risk free rate and also on the basis of
Risks adjusted discount rate.

Answer :

The Present Value of the Cash Flows for all the years by discounting the cash flow at 7%
is calculated as below:

Year Cash flows Discounting Present value of Cash

` in lakhs Factor@7% Flows ` in lakhs
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less Initial investment 100
Net Present Value (NPV) 144.34

Now when the risk-free rate is 7 % and the risk premium expected by the Management is 7
%. So the risk adjusted discount rate is 7 % + 7 % =14%.

SANJAY SARAF SIR 420

CA INTER FINANCIAL MANAGEMENT

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as
below :
Year Cash flows Discounting Present Value of Cash
` in Lakhs Factor@14% Flows ` in lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.79
Initial investment 100
Net present value (NPV) 99.79

Question 6

If Investment Proposal is ` 45,00,000 and risk free rate is 5%, calculate Net present value
under certainty equivalent technique.
Year Expected cash flow (`) Certainty Equivalent coefficient

1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78

Answer :

– 45,0000

= ` 5,34,570

SANJAY SARAF SIR 421

 RISK ANALYSIS IN CAPITAL BUDGETING

Question 7

X Ltd is considering its New Product ‘with the following details

Sr. No. Particulars Figures
1 Initial capital cost ` 400 Cr
2 Annual unit sales ` 5 Cr
3 Selling price per unit ` 100
4 Variable cost per unit ` 50
5 Fixed costs per year ` 50 Cr
6 Discount Rate 6%

1. Calculate the NPV of the project.

2. Find the impact on the project’s NPV of a 2.5 per cent adverse variance in each
variable. Which variable is having maximum effect.

Answer :

1. Calculation of Net Cash Inflow per year :

Particulars Amount (`)
A Selling Price Per Unit (A) 100
B Variable Cost Per Unit (B) 50
C Contribution Per Unit (C = A-B) 50
D Number of Units Sold Per Year 5 Cr.
E Total Contribution (E = C X D) ` 250 Cr.
F Fixed Cost Per Year ` 50 Cr.
G Net Cash Inflow Per Year (G =E - F) ` 200 Cr.

Calculation of Net Present Value (NPV) of the Project:

Year Year Cash Flow (` in Cr.) Discounting @ 6% Present Value (PV) (` in Cr.)

0 -400 1.000 -400

1 200 0.943 188.60
2 200 0.890 178
3 200 0.840 168
Net Present Value (188.60 + 178 +168) - 400= 134.60

SANJAY SARAF SIR 422

CA INTER FINANCIAL MANAGEMENT

Here NPV represent the most likely outcomes and not the actual outcomes. The actual
outcome can be lower or higher than the expected outcome.

2. Sensitivity Analysis considering 2.5 % Adverse Variance in each variable

Initial Selling
Variable Fixed
Cash Price
Cost Per Cost Per Units sold per
Changes in Flow per
Base Unit Unit year reduced to
variable increased Unit
increased increased ` 4.875 crore
to ` 410 Reduced to
to ` 51.25 to ` 51.25
crore ` 97.5
Particulars Amount Amount Amount Amount Amount Amount
` ` ` ` ` `
A Selling Price 100 100 97.5 100 100 100
Per Unit (A)
B Variable Cost 50 50 50 51.25 50 50
Per Unit (B)
C Contribution 50 50 47.5 48.75 50 50
Per Unit
(C = A-B)
D Number of 5 5 5 5 5 4.875
Units Sold Per
Year (in
Crores)
E Total 250 250 237.5 243.75 250 243.75
Contribution
(E = C × D )
F Fixed Cost Per 50 50 50 50 51.25 50
Year (in
Crores)
G Net Cash 200 200 187.5 193.75 198.75 193.75
Inflow
Per Year
( G =E - F)
H (G × 2.673) 534.60 534.60 501.19 517.89 531.26 517.89
I Initial Cash 400 410 400 400 400 400
Flow
J NPV 134.60 124.60 101.19 117.89 131.26 117.89
K Percentage -7.43% -24.82% -12.41% -2.48% -12.41%
Change in
NPV

The above table shows that the by varying one variable at a time by 2.5% while keeping the
others constant, the impact in percentage terms on the NPV of the project. Thus it can be
seen that the change in selling price has the maximum effect on the NPV by 24.82 %.
SANJAY SARAF SIR 423
 RISK ANALYSIS IN CAPITAL BUDGETING

Question 8

XYZ Ltd. is considering a project “A” with an initial outlay of ` 14,00,000 and the possible
three cash inflow attached with the project as follows :
Particular Year 1 Year 2 Year 3
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900

Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain
about the most likely result but uncertain about the third year’s cash flow, what will be the
NPV expecting worst scenario in the third year.

Answer :

The possible outcomes will be as follows :

Worst Case Most likely Best case

PVF
Year @ 9% Cash Flow Cash Cash
PV PV PV
Flow Flow
(` 000)
(` 000) (` 000) (` 000) (` 000) (` 000)
0 1 (1400) (1400) (1400) (1400) (1400) (1400)
1 0.917 450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421.00
3 0.772 700 540.40 800 617.60 900 694.80
NPV -110.15 100.85 311.85

Now suppose that CEO of XYZ Ltd. is bit confident about the estimates in the first
two years, but not sure about the third year’s high cash inflow. He is interested in
knowing what will happen to traditional NPV if 3rd year turn out the bad contrary to his
optimism.
The NPV in such case will be as follows:

= −`14,00,000 + ` 5,04,587 + ` 3,78,756 + ` 5,40,528 = ` 23,871

SANJAY SARAF SIR 424

CA INTER FINANCIAL MANAGEMENT

Question 9

Annual Net Cash Flow & Life of the project with their probability distribution are
as follows :
Annual Cash Flow Project Life

Value (`) Probability Value (Year) Probability

10,000 0.02 3 0.05

15,000 0.03 4 0.10
20,000 0.15 5 0.30
25,000 0.15 6 0.25
30,000 0.30 7 0.15
35,000 0.20 8 0.10
40,000 0.15 9 0.03
10 0.02

Risk free rate is 10%, and Initial Investment is ` 1,30,000.

Various Random Number generated are as follows:
53479 81115 980z36 12217 59526
97344 70328 58116 91964 26240
66023 38277 74523 71118 84892
99776 75723 03172 43112 83086
30176 48979 92153 38416 42436
81874 83339 14988 99937 13213
19839 90630 71863 95053 55532
09337 33435 53869 52769 18801
31151 58295 40823 41330 21093
67619 52515 03037 81699 17106

Calculate NPV in each Run.

SANJAY SARAF SIR 425

 RISK ANALYSIS IN CAPITAL BUDGETING

Answer :

Correspondence between Values of Variables and two Digit Random Numbers:

Annual Cash Flow Project Life
Value (`) Probability Cumulative Two Digit Value Probability Cumulative Two
Probability Random No. (Year) Probability Digit
Random
No.
10,000 0.02 0.02 00 – 01 3 0.05 0.05 00 – 04
15,000 0.03 0.05 02 – 04 4 0.10 0.15 05 – 14
20,000 0.15 0.20 05 – 19 5 0.30 0.45 15 – 44
25,000 0.15 0.35 20 – 34 6 0.25 0.70 45 – 69
30,000 0.30 0.65 35 – 64 7 0.15 0.85 70 – 84
35,000 0.20 0.85 65 – 84 8 0.10 0.95 85 – 94
40,000 0.15 1.00 85 - 99 9 0.03 0.98 95 – 97
10 0.02 1.00 98 - 99

For the first simulation run we need two digit random numbers (1) For Annual Cash Flow
(2) For Project Life. The numbers are 53 & 97 and corresponding value of Annual Cash
Flow and Project Life are ` 30,000 and 9 years respectively and so on.

Calculation of NPV through Simulation

Annual Cash Flow Project Life
Run Random Annual Cash Random Project PVAF NPV (1)x(2)
No. Flow No. Life @ 10% – 1,30,000
(1) (2)
1 53 30,000 97 9 5.759 42,770*
2 66 35,000 99 10 6.145 85,075
3 30 25,000 81 7 4.868 (8,300)
4 19 20,000 09 4 3.170 (66,600)
5 31 25,000 67 6 4.355 (21,125)
6 81 35,000 70 7 4.868 40,380
7 38 30,000 75 7 4.868 16,040
8 48 30,000 83 7 4.868 16,040
9 90 40,000 33 5 3.791 21,640
10 58 30,000 52 6 4.355 650

*(30,000 × 5.759 – 1,30,000), Cumulative PV @ 10% for 9 years is 5.759, NPV of other runs
are calculated similarly.

SANJAY SARAF SIR 426

CA INTER FINANCIAL MANAGEMENT

Question 10

A firm has an investment proposal, requiring an outlay of ` 80,000. The investment

proposal is expected to have two years’ economic life with no salvage value. In year 1, there
is a 0.4 probability that cash inflow after tax will be ` 50,000 and 0.6 probability that cash
inflow after tax will be ` 60,000. The probability assigned to cash inflow after tax for the
year 2 is as follows :
Year Cash Flows (`) Probability Cash Flows (`) Probability
Year-1 ` 50,000 0.6 ` 60,000 0.4
Year- 2
` 24,000 0.2 ` 40,000 0.4
` 32,000 0.3 ` 50,000 0.5
` 44,000 0.5 ` 60,000 0.1

The firm uses a 10% discount rate for this type of investment.

Required:
i. Construct a decision tree for the proposed investment project and calculate the
expected net present value (NPV).
ii. What net present value will the project yield, if worst outcome is realized? What is the
probability of occurrence of this NPV?
iii. What will be the best outcome and the probability of that occurrence?
iv. Will the project be accepted?
(Note: 10% discount factor 1 year 0.909; 2 years 0.826)

Answer :

i. The decision tree diagram is presented in the chart, identifying various paths and
outcomes, and the computation of various paths/outcomes and NPV of each path are
presented in the following tables:

SANJAY SARAF SIR 427

 RISK ANALYSIS IN CAPITAL BUDGETING

The Net Present Value (NPV) of each path at 10% discount rate is given below:

Path Year 1 Year 2 Total Cash Cash NPV

Cash Flows Cash Flows Inflows (PV) Outflows

(`) (`) (`) (`) (`)

50,000 × 0.909 24,000 ×0.826

1 65,274 80,000 (14,726)
= 45,450 = 19,824
32,000 × 0.826
2 45,450 71,882 80,000 (8,118)
= 26,432
44,000 × 0.826
3 45,450 81,794 80,000 1,794
= 36,344
60,000 × 0.909 40,000 × 0.826
4 87,580 80,000 7,580
= 54,540 = 33,040
50,000 × 0.826
5 54,540 95,840 80,000 15,840
= 41,300
60,000 × 0.826
6 54,540 1,04,100 80,000 24,100
= 49,560

Statement showing Expected Net Present Value

z NPV (`) Joint Probability Expected NPV (`)

1 (14,726) 0.08 (1,178.08)
2 (8,118) 0.12 (974.16)
3 1,794 0.20 358.80
4 7,580 0.24 1,819.20
5 15,840 0.30 4,752.00
6 24,100 0.06 1,446.00
6,223.76

ii. If the worst outcome is realized the project will yield NPV of – ` 14,726. The
probability of occurrence of this NPV is 8% and a loss of ` 1,178 (path 1).
iii. The best outcome will be path 6 when the NPV is at ` 24,100. The probability of
occurrence of this NPV is 6% and an expected profit of ` 1,446.
iv. The project should be accepted because the expected NPV is positive at ` 6,223.76 based
on joint probability

SANJAY SARAF SIR 428

CA INTER FINANCIAL MANAGEMENT

Question 11

Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs
` 36,000 and project B ` 30,000. You have been given below the net present value
probability distribution for each project.

Project A Project B
NPV estimates Probability NPV estimates Probability
(`) (`)
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1

i. Compute the expected net present values of projects A and B.

ii. Compute the risk attached to each project i.e. standard deviation of each probability
distribution.
iii. Compute the profitability index of each project.
iv. Which project do you recommend? State with reasons.

Answer :

i. Statement showing computation of expected net present value of Projects A and B:

Project A Project B
NPV Probability Expected NPV Probability Expected
Estimate (`) Value Estimate Value
15,000 0.2 3,000 15,000 0.1 1,500
12,000 0.3 3,600 12,000 0.4 4,800
6,000 0.3 1,800 6,000 0.4 2,400
3,000 0.2 600 3,000 0.1 300
1.0 EV = 9,000 1.0 EV = 9,000

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 RISK ANALYSIS IN CAPITAL BUDGETING

ii. Computation of Standard deviation of each project

Project A
P X (X – EV) P (X- EV)²
0.2 15,000 6,000 72,00,000
0.3 12,000 3,000 27,00,000
0.3 6,000 - 3,000 27,00,000
0.2 3,000 - 6,000 72,00,000
Variance = 1,98,00,000

Standard Deviation of Project A = 1,98,00,000 = `4,450

Project B
P X (X – EV) P (X- EV)²
0.1 15,000 6,000 36,00,000
0.4 12,000 3,000 36,00,000

0.4 6,000 - 3,000 36,00,000

0.1 3,000 - 6,000 36,00,000

Variance = 1,44,00,000

Standard Deviation of Project B = 1,44,00,000 = ` 3,795

iii. Computation of profitability of each project

Profitability index = Discount cash inflow / Initial outlay
In case of Project A : PI

In case of Project B : PI

iv. Measurement of risk is made by the possible variation of outcomes around the expected
value and the decision will be taken in view of the variation in the expected
value where two projects have the same expected value, the decision will be the
project which has smaller variation in expected value. In the selection of one of the two
projects A and B, Project B is preferable because the possible profit which may occur is
subject to less variation (or dispersion). Much higher risk is lying with project A.

SANJAY SARAF SIR 430

CA INTER FINANCIAL MANAGEMENT

Question 12

From the following details relating to a project, analyse the sensitivity of the project to
changes in initial project cost, annual cash inflow and cost of capital :
Initial Project Cost (`) 1,20,000
Annual Cash Inflow (`) 45,000
Project Life (Years) 4
Cost of Capital 10%

To which of the three factors, the project is most sensitive if the variable is
adversely affected by 10%? (Use annuity factors: for 10% 3.169 and 11% ... 3.103).

Answer :

Calculation of NPV through Sensitivity Analysis

(`)
PV of cash inflows (` 45,000 × 3.169 ) 1,42,605
Initial Project Cost (1,20,000)
NPV 22,605

Situation NPV Changes in NPV

Base(present) ` 22,605
If initial project cost is (` 1,42,605 - ` 1,32,000 ) (` 22,605 – ` 10,605)/`22,605
varied adversely by 10% = ` 10,605 = (53.08%)

If annual cash inflow is [`40,500(revised cash flow) (` 22,605 – ` 8,345) /` 22,605

varied adversely by 10% × 3.169) – (` 1,20,000)] =63.08%
= ` 8,345
If cost of capital is (` 45,000 × 3.103) –` 1,20,000 (` 22,605 – ` 19,635) /`22,605
varied adversely by 10% = ` 19,635 = 13.14%
i.e. it becomes 11%

Conclusion : Project is most sensitive to ‘annual cash inflow’

SANJAY SARAF SIR 431

 RISK ANALYSIS IN CAPITAL BUDGETING

 PRACTICE QUESTIONS

Source : ICAI, SM (New) - ( Question No. 1 & 2 )

Question 1

The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive
proposals, Projects M and N, which require cash outlays of ` 8,50,000 and ` 8,25,000
respectively. The certainty-equivalent (C.E) approach is used in incorporating risk in
capital budgeting decisions. The current yield on government bonds is 6% and this is used
as the risk free rate. The expected net cash flows and their certainty equivalents are as
follows:

Project M Project N
Year end Cash Flow (`) C.E. Cash Flow (`) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7

Present value factors of ` 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890
and 0.840 respectively.

Required :
i. Which project should be accepted?
ii. If risk adjusted discount rate method is used, which project would be appraised with a
higher rate and why?

Answer :

i. Statement Showing the Net Present Value of Project M

Year end Cash Flow C.E. Adjusted Present value Total Present
(`) Cash factor at value (`)
(a) (b) flow (`) 6%(d) (e) = (c) ×(d)
(c) = (a) × (b)
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
8,60,980
Less: Initial Investment 8,50,000
Net Present Value 10,980

SANJAY SARAF SIR 432

CA INTER FINANCIAL MANAGEMENT

Statement Showing the Net Present Value of Project N

Year end Cash Flow C.E. Adjusted Present value Total Present
(`) Cash factor at value (`)
(a) (b) flow (`) 6%(d) (e) = (c) ×(d)
(c) = (a) × (b)
1 4,50,000 0.9 4,05,000 0.943
3,81,915
2 4,50,000 0.8 3,60,000 0.890
3,20,400
3 5,00,000 0.7 3,50,000 0.840
2,94,000
9,96,315
Less: Initial Investment 8,25,000
Net Present Value 1,71,315
Decision : Since the net present value of Project N is higher, so the project N
should be accepted.

ii. Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project N (2.4).
This means Project M is riskier than Project N as “higher the riskiness of a cash flow, the
lower will be the CE factor”. If risk adjusted discount rate (RADR) method is used,
Project M would be analysed with a higher rate.

Question 2

Determine the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays (`) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (`) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4

The Company selects the risk-adjusted rate of discount on the basis of the coefficient
of variation:
P.V. Factor 1 to 5 years At risk
Coefficient of
Risk-Adjusted Rate of Return adjusted rate of
Variation
discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689

SANJAY SARAF SIR 433

 RISK ANALYSIS IN CAPITAL BUDGETING

Answer :

Statement showing the determination of the risk adjusted net present value

Risk
Net Coefficient Annual Net
adjusted PV factor Discounted
Projects cash of cash present
discount 1-5 years cash inflow
outlays variation inflow value
rate
(`) (`) (`) (`)
(i) (ii) (iii) (iv) (v) (vi) (vii) (viii)
= (v) × (vi) = (vii) − (ii)
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180
Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186
Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150

SANJAY SARAF SIR 434

CA INTER FINANCIAL MANAGEMENT

 OTHER PROBLEMS

Question 1

Gauav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The
following information regarding a new project is as follows:

Year Expected Cash flow Certainty-equivalent quotient

0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3

Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether
the project should be accepted?
Source : ICAI, RTP November 2018 (New)
Answer :

Determination of Net Present Value (NPV)

Year Expected Certainty- Adjusted Cash flow PV factor Total PV

Cash flow (`) equivalent (Cash flow × CE) (at 0.06) (`)
(CE) (`)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032
5 1,60,000 0.3 48,000 0.747 35,856
NPV = (6,58,776 – 4,00,000) 2,58,776

As the Net Present Value is positive the project should be accepted.

SANJAY SARAF SIR 435

 RISK ANALYSIS IN CAPITAL BUDGETING

 THEORETICAL QUESTIONS

Question 1

State the disadvantages of the Certainty equivalent Method. Explain its differences with
Risk Adjusted discount rate.
Source : ICAI, MTP II (New)
Answer :

Disadvantages of Certainty Equivalent Method

1. There is no Statistical or Mathematical model available to estimate certainty
Equivalent. Assumption of risk being subjective, it varies on the perception of the risk
by the management because of bias and individual opinions involved.
2. There is no objective or mathematical method to estimate certainty equivalents.
Certainty Equivalent are subjective and vary as per each individual’s estimate.
3. Certainty equivalents are decided by the management based on their perception
of risk. However the risk perception of the shareholders who are the money lenders for
the project is ignored. Hence it is not used often in corporate decision making .

Risk-adjusted Discount Rate Vs. Certainty-Equivalent

Certainty Equivalent Method is superior to Risk Adjusted Discount Rate Method as
it does not assume that risk increases with time at constant rate. Each year's Certainty
Equivalent Coefficient is based on level of risk impacting its cash flow. Despite its
soundness, it is not preferable like Risk Adjusted Discount Rate Method. It is difficult to
specify a series of Certainty Equivalent Coefficients but simple to adjust discount rates.

Question 2

What is certainty Equivalent?

Source : ICAI, May 2018 Question Paper
Answer :

Certainty Equivalent (CE)

It is a coefficient used to deal with risk in a capital budgeting context. It expresses risky
future cash flows in terms of the certain cash flows which would be considered by
the decision maker, as their equivalent. That is the decision maker would be
indifferent between the risky amount and the (Lower) riskless amount considered to
be its equivalent.

SANJAY SARAF SIR 436

CA INTER FINANCIAL MANAGEMENT

It is a guaranteed return that the management would accept rather than accepting a
higher but uncertain return. Calculation of this equivalent involves the following
three steps:

Step 1: Remove risks by substituting equivalent certain cash flows in the place of risky
cash flows. This can be done by multiplying each risky cash flow by the appropriate CE
Coefficient.
Step 2: Obtain discounted value of cash flow by applying riskless rate of interest.
Step 3: Apply normal capital budgeting method to calculate NPV by using the firm’s
required rate of return.

Where,
NCFt = the forecasts of net cash flow without risk-adjustment
αt = the risk-adjustment factor or the certainly equivalent coefficient.
Kf = risk-free rate assumed to be constant for all periods.
Certainty Coefficient lies between 0 and 1.

Question 3

“The higher risk of a project can be recognised by decreasing the required rate of return
of the project”. Comment.
Source : ICAI, RTP November 2013 (Old)
Answer :

The higher risk of a project can be recognised by decreasing the required rate of
return of the project. This statement is not true. In fact the higher the risk of the
project, the greater is the required rate of return of the project.

SANJAY SARAF SIR 437

 November 2018 Question Paper

FINANCIAL MANAGEMENT
Section A
1.
a. Y Limited requires ` 50,00,000 for a new project. This project is expected to yield
earnings before interest and taxes of `10,00,000. While deciding about the financial
plan, the company considers the objective of maximising earnings per share. It has
two alternatives to finance the project - by raising debt ` 5,00,000 or ` 20,00,000 and
the balance, in each case, by issuing Equity Shares. The company's share is currently
selling at ` 300, but is expected to decline to ` 250 in case the funds are borrowed in
excess of ` 20,00,000. The funds can be borrowed at the rate of 12 percent upto
`5,00,000 and at 10 percent over ` 5,00,000. The tax rate applicable to the company is
25 percent.
Which form of financing should the company choose?

b. Following information relating to Jee Ltd. are given :

Particulars
Profit after tax `10,00,000
Dividend payout ratio 50%
Number of Equity Shares 50,000
Cost of Equity 10%
Rate of Return on Investment 12%

i. What would be the market value per share as per Walter's Model?
ii. What is the optimum dividend payout ratio according to Walter's Model and
Market value of equity share at that payout ratio?

c. The following is the information of XML Ltd. relate to the year ended 31.03.2018
Gross Profit 20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months
Non-Current Assets to Sales 1:4
Non-Current Assets to Current Assets 1:2
Current Ratio 2:1
Non-Current Liabilities to Current Liabilities 1:1
Share Capital to Reserve and Surplus 4:1
Non-current Assets as on 31st March, 2017 `50,00,000

SANJAY SARAF SIR 438

 Assume that
i. No change in Non-Current Assets during the year 2017-18
ii. No depreciation charged on Non-Current Assets during the year 2017-18
iii. Ignoring Tax
You are required to Calculate cost of goods sold. Net profit, Inventory, Receivables
and Cash for the year ended on 31st March, 2018

d. From the following details relating to a project, analyse the sensitivity of the project
to changes in the Initial Project Cost, Annual Cash Inflow and Cost of Capital :

Particulars
Initial Project Cost ` 2,00,00,000
Annual Cash Inflow ` 60,00,000
Project Life 5 years
Cost of Capital 10%

To which of the 3 factors, the project is most sensitive if the variable is adversely
affected by 10%?
Cumulative Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696

2. Following is the Balance Sheet of Soni Ltd. as on 31st March, 2018 :

Liabilities Amount in `
Shareholder's Fund
Equity Share Capital (` 10 each) 25,00,000
Reserve and Surplus 5,00,000
Non-Current Liabilities (12% Debenture) 50,00,000
Current Liabilities 20,00,000
Total 1,00,00,000
Non-Current Assets 60,00,000
Assets Amount in `
Non-Current Assets 60,00,000
Current Assets 40,00,000
Total 1,00,00,000
Additional Information :
i. Variable Cost is 60% of Sales
ii. Fixed Cost p.a excluding interest ` 20,00,000
iii. Total Asset Turnover Ratio is 5 times.
iv. Income Tax Rate 25%

SANJAY SARAF SIR 439

 You are required to :
1. Prepare Income Statement
2. Calculate the following and comment :
a. Operating Leverage
b. Financial Leverage
c. Combined Leverage

3. PD Ltd. an existing company, is planning to introduce a new product with projected life
of 8 years. Project cost will be ` 2,40,00,000. At the end of 8 years no residual value will
be realized. Working capital of ` 30,00,000 will be needed. The 100% capacity of the
project is 2,00,000 units p.a. but the Production and Sales Volume is expected are as
under :
Year Number of Units
1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units

Other Information :
i. Selling price per unit ` 200
ii. Variable cost is 40% of sales
iii. Fixed cost p.a ` 30,00,000
iv. In addition to these advertisement expenditure will have to be incurred as under :
Year 1 2 3-5 6-8
Expenditure (`) 50,00,000 25,00,000 10,00,000 5,00,000

v. Income Tax is 25%

vi. Straight line method of depreciation is permissible for tax purpose.
vii. Cost of capital is 10%
viii. Assume that loss cannot be carried forward.

Present Value Table

Year 1 2 3 4 5 6 7 8
PVF @ 10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Advise about the project acceptability

SANJAY SARAF SIR 440

4. MN Ltd. a current turnover of ` 30,00,000 p.a. Cost of Sale is 80% of turnover and Bad
Debts are 2% of turnover, Cost of Sales includes 70% variable cost and 30% Fixed Cost,
while company's required rate of return is 15%. MN Ltd. currently allows 15 days credit
to its customer, but it is considering increase this to 45 days credit in order to increase
turnover.
It has been estimated that this change in policy will increase turnover by 20%, while Bad
Debts will increase by 1%. It is not expected that the policy change will result in an
increase in fixed cost and creditors and stock will be unchanged.
Should MN Ltd. introduce the proposed policy? (Assume a 360 days year)

5. The following data relate to two companies belonging to the same risk class :

Particulars A Ltd. B Ltd.

Expected Net Operating Income `18,00,000 `18,00,000
12% Debt ` 54,00,000 -
Equity Capitalization Rate - 18%

Required :
a. Determine the total market value, Equity capitalization rate and weighted average
cost of capital for each company assuming no taxes as per M.M. Approach.
b. Determine the total market value, Equity capitalization rate and weighted average
cost of capital for each company assuming 40% taxes as per M.M. Approach.

6. Answer the following :

a. Explain in brief following Financial Instruments :
(i) Euro Bonds
(ii) Floating Rate Notes
(iii) Euro Commercial paper
(iv) Fully Hedged Bond

b. Discuss the Advantages of Leasing

c. Write two main objectives of Financial Management.

OR

Write two main reasons for considering risk in Capital Budgeting decisions.

SANJAY SARAF SIR 441

 ANSWERS

1.
a. Plan I = Raising Debt of Rs 5 lakh + Equity of Rs 45 lakh.
Plan II = Raising Debt of ` 20 lakh + Equity of ` 30 lakh.

Calculation of Earnings per share (EPS)

Financial Plans
Particulars Plan I Plan II
` `
Expected EBIT 10,00,000 10,00,000
Less: Interest (Working Note 1) (60,000) (2,10,000)
Earnings before taxes 9,40,000 7,90,000
Less: Taxes @ 25% (2,35,000) (1,97,500)
Earnings after taxes (EAT) 7,05,000 5,92,500
Number of shares (Working Note 2) 15,000 10,000
Earnings per share (EPS) 47 59.25

Financing Plan II (i.e. Raising debt of ` 20 lakh and issue of equity share capital of
` 30 lakh) is the option which maximises the earnings per share.

Working Notes:

1. Calculation of interest on Debt.

Plan I (` 5,00,000  12%) `60,000

Plan II (` 5,00,000  12%) ` 60,000
(` 15,00,000  10%) ` 1,50,000 `2,10,000

2. Number of equity shares to be issued

` 45,00,000
Plan I: = 15,000 shares
` 300 (Market Price of share)

` 30,00,000
Plan II: = 10,000 shares
` 300 (Market Price of share)

(*Alternatively, interest on Debt for Plan II can be 20,00,000 X 10% i.e. `

2,00,000. accordingly, the EPS for the Plan II will be `60)

SANJAY SARAF SIR 442

b.
i. Walter’s model is given by –
D + (E - D)(r / K e )
P
Ke
Where,
P = Market price per share,
E = Earnings per share = ` 10,00,000 ÷ 50,000 = ` 20
D = Dividend per share = 50% of 20 = ` 10
r = Return earned on investment = 12%
Ke = Cost of equity capital = 10%

ii. According to Walter’s model when the return on investment is more than the
cost of equity capital, the price per share increases as the dividend pay-out ratio
decreases. Hence, the optimum dividend pay-out ratio in this case is Nil. So, at a
payout ratio of zero, the market value of the company’s share will be:-

c. Workings

Non Current Assets 1


Current Assets 2
50,00,000 1
Or 
Current Assets 2
So, Current Assets = ` 1,00,00,000
Now further,
Non Current Assets 1

Sales 4
50,00,000 1
Or 
Sales 4
So, Sales = ` 2,00,00,000

Calculation of Cost of Goods sold, Net profit, Inventory, Receivables and Cash:

i. Cost of Goods Sold (COGS):

Cost of Goods Sold = Sales- Gross Profit
= ` 2,00,00,000 – 20% of ` 2,00,00,000
= ` 1,60,00,000

SANJAY SARAF SIR 443

 ii. Net Profit = 10% of Sales = 10% of ` 2,00,00,000
= ` 20,00,000

iii. Inventory:
12 Months
Inventory Holding Period =
Inventory Turnover Ratio
Inventory Turnover Ratio = 12/ 3 = 4
COGS
4=
Average Inventory
1,60,00,000
4=
Average Inventory
Average or Closing Inventory =` 40,00,000

iv. Receivables :
12 Months
Receivable Collection Period =
Receivables Turnover Ratio
Credit Sales
Or Receivables Turnover Ratio = 12/3 = 4 =
Average Accounts Receivable
2,00,00,000
Or 4=
Average Accounts Receivable
So, Average Accounts Receivable/Receivables =` 50,00,000/-

v. Cash:
Cash* = Current Assets* – Inventory- Receivables
Cash = ` 1,00,00,000 - ` 40,00,000 - ` 50,00,000
= ` 10,00,000
(it is assumed that no other current assets are included in the Current Asset)

d. Calculation of NPV through Sensitivity Analysis

`
PV of cash inflows (` 60,00,000 × 3.791) 2,27,46,000
Initial Project Cost 2,00,00,000
NPV 27,46,000

Situation NPV Changes in NPV

Base(present) ` 27,46,000
If initial project cost is (` 2,27,46,000 – ( ` 27,46,000 - ` 7,46,000)
varied adversely by 10% ` 2,20,00,000*) ` 27,46,000
= ` 7,46,000 = (72.83%)

SANJAY SARAF SIR 444

 If annual cash inflow is [` 54,00,000(revised ( ` 27,46,000 - ` 4,71,400)
varied adversely by 10% cash flow) ** × 3.791) – ` 27, 46,000
(` 2,00,00,000)] = 82.83%
= ` 4,71,400
If cost of capital is varied (` 60,00,000 × 3.696) – ( ` 27, 46,000 - ` 21,76, 400)
adversely by 10% i.e. it ` 2,00,00,000 ` 27, 46,000
becomes 11% = ` 21,76,000 = 20.76%

*Revised initial project Cost = 2,00,00,000 × 110% = 2,20,00,000

**Revised Cash Flow = ` 60,00,000 x (100 – 10) % = ` 54,00,000

Conclusion: Project is most sensitive to ‘annual cash inflow’

2. Workings:-
Total Assets = ` 1 crore
Total Sales
Total Asset Turnover Ratio i.e.
Total Assets =5
Hence, Total Sales = ` 1 Crore  5 = ` 5 crore

1. Income Statement

(` in crore)
Sales 5
Less: Variable cost @ 60% 3
Contribution 2
Less: Fixed cost (other than Interest) 0 .2
EBIT (Earnings before interest and tax) 1.8
Less: Interest on debentures (12%  50 lakhs) 0 .06
EBT (Earning before tax) 1.74
Less: Tax 25% 0.435
EAT (Earning after tax) 1.305

2.
a. Operating Leverage
Contribution 2
Operating leverage =   1.11
EBIT 1.8
It indicates fixed cost in cost structure. It indicates sensitivity of earnings
before interest and tax (EBIT ) to change in sales at a particular level.

SANJAY SARAF SIR 445

 b. Financial Leverage

EBIT 1.8
Financial Leverage =   1.03
EBT 1.74
The financial leverage is very comfortable since the debt service obligation is
small vis-à-vis EBIT .

c. Combined Leverage

Contribution EBIT
Combined Leverage =   1.11  1.03 = 1.15
EBIT EBT
Or
Contribution 2
  1.15
EBT 1.74
The combined leverage studies the choice of fixed cost in cost structure
and choice of debt in capital structure. It studies how sensitive the change in
EPS is vis-à-vis change in sales.

The leverages - operating, financial and combined are measures of risk.

3. Computation of initial cash outlay(COF)

(` in lakhs)
Project Cost 240
Working Capital 30
270

Calculation of Cash Inflows(CIF):

Years 1 2 3-5 6-8

Sales in units 60,000 80,000 1,40,000 1,20,000
` ` ` `
Contribution (`200 x 60% x
72,00,000 96,00,000 1,68,00,000 1,44,00,000
No. of Unit)
Less: Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000
Less: Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
Less: Depreciation (24000000/8)
30,00,000 30,00,000 30,00,000 30,00,000
= 30,00,000
Profit /(loss) (38,00,000) 11,00,000 98,00,000 79,00,000
Less: Tax @ 25% NIL 2,75,000 24,50,000 19,75,000
Profit/(Loss) after tax (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
Cash inflow (8,00,000) 38,25,000 1,03,50,000 89,25,000
(Note: Since variable cost is 40%, Contribution shall be 60% of sales)

SANJAY SARAF SIR 446

 Computation of PV of CIF

CIF PV Factor
Year `
` @ 10%
1 (8,00,000) 0.909 (7,27,200)
2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 89,25,000 0.467 55,68,975
Working Capital 30,00,000
3,88,82,700
PV of COF 2,70,00,000
NPV 1,18,82,700

Recommendation: Accept the project in view of positive NPV.

4.
Statement Showing Evaluation of Credit Policies

Present Proposed
Particulars
Policy Policy
A. Expected Contribution
(a) Credit Sales 30,00,000 36,00,000
(b) Less: Variable Cost 16,80,000 20,16,000
(c) Contribution 13,20,000 15,84,000
(d) Less: Bad Debts 60,000 1,08,000
(e) Contribution after Bad debt [(c)-(d)] 12,60,000 14,76,000
B. Opportunity Cost of investment in Receivables 15,000 54,000
C. Net Benefits [A-B] 12,45,000 14,22,000
D. Increase in Benefit 1,77,000

Recommendation: Proposed Policy i.e credit from 15 days to 45 days should be

implemented by NM Ltd since the net benefit under this policy are higher than those
under present policy

SANJAY SARAF SIR 447

 Working Note: (1)

Present Policy Propose Policy

(`) (`)
Sales 30,00,000 36,00,000
Cost of Sales (80% of sales) 24,00,000 28,80,000
Variable cost (70% of cost of sales) 16,80,000 20,16,000

(2) Opportunity Costs of Average Investments

Collection Period
= Variable Cost   Rate of Return
360
45
Present Policy = ` 24,00,000   15%  ` 54,000
360
15
Proposed Policy = ` 28,80,000   15%  ` 18, 000
360

5.
a. Assuming no tax as per MM Approach.
Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]
Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = ` 1,00,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL)
= Vu + (Debt × Nil) = ` 1,00,00,000 + (54,00,000 × nil)
= `1,00,00,000

Computation of Equity Capitalization Rate

and Weighted Average Cost of Capital (WACC)

Particulars A Ltd. B Ltd.

A Net Operating Income (NOI) 18,00,000 18,00,000
B Less: Interest on Debt (I) 6,48,000 -
C Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,000

SANJAY SARAF SIR 448

 H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital 0.18 0.18
[WACC (ko)]* ko = (ke × S/V) + (kd × D/V)

*Computation of WACC A Ltd.

Component of Capital Amount Weight Cost of Capital WACC

Equity 46,00,000 0.46 0.2504 0.1152
Debt 54,00,000 0.54 0.12* 0.0648
Total 81,60,000 0.18

*Kd = 12% (since there is no tax)

WACC = 18%

b. Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]
Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)] / 0.18
= `60,00,000
Ke of unlevered Firm (given) = 0.18
Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Tax)
= ` 60,00,000 + (54,00,000 × 0.4)
= ` 81,60,000

Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.’

= 18% (i.e. Ke = Ko)

Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC) of a Ltd

Particulars A Ltd.
Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before Tax (EBT) 11,52,000
Less: Tax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
Total Value of Firm (V) as calculated above 81,60,000
Less: Market Value of Debt 54,00,000

SANJAY SARAF SIR 449

 Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [ke = NI/S] 0.2504
Weighted Average Cost of Capital (ko)* 13.23
ko = (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC

Equity 27,60,000 0.338 0.2504 0.0846
Debt 54,00,000 0.662 0.072* 0.0477
Total 81,60,000 0.1323

*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2%

WACC = 13.23%

6.
a.
(i) Euro bonds: Euro bonds are debt instruments which are not denominated
in the currency of the country in which they are issued. E.g. a Yen note floated in
Germany.
(ii) Floating Rate Notes: Floating Rate Notes are issued up to seven years
maturity. Interest rates are adjusted to reflect the prevailing exchange rates.
They provide cheaper money than foreign loans.
(iii) Euro Commercial Paper(ECP): ECPs are short term money market instruments.
They are for maturities less than one year. They are usually designated in
US Dollars.
(iv) Fully Hedged Bond: In foreign bonds, the risk of currency fluctuations exists.
Fully hedged bonds eliminate the risk by selling in forward markets the
entire stream of principal and interest payments.

b.
(i) Lease may low cost alternative: Leasing is alternative to purchasing. As the
lessee is to make a series of payments for using an asset, a lease arrangement
is similar to a debt contract. The benefit of lease is based on a comparison between
leasing and buying an asset. Many lessees find lease more attractive because
of low cost.
(ii) Tax benefit: In certain cases tax benefit of depreciation available for owning
an asset may be less than that available for lease payment
(iii) Working capital conservation: When a firm buy an equipment by borrowing
from a bank (or financial institution), they never provide 100% financing. But

SANJAY SARAF SIR 450

 in case of lease one gets normally 100% financing. This enables conservation
of working capital.
(iv) Preservation of Debt Capacity: So, operating lease does not matter in computing
debt equity ratio. This enables the lessee to go for debt financing more easily.
The access to and ability of a firm to get debt financing is called debt capacity
(also, reserve debt capacity).
(v) Obsolescence and Disposal: After purchase of leased asset there may be
technological obsolescence of the asset. That means a technologically upgraded
asset with better capacity may come into existence after purchase. To retain
competitive advantage the lessee as user may have to go for the upgraded asset.

c. Two Main Objective of Financial Management

Profit Maximisation
It has traditionally been argued that the primary objective of a company
is to earn profit; hence the objective of financial management is also profit
maximisation.

Wealth / Value Maximization

Wealth /Value Maximization Model. Shareholders wealth are the result of cost
benefit analysis adjusted with their timing and risk i.e. time value of money.
This is the real objective of Financial Management. So,

Wealth = Present Value of benefits – Present Value of Costs

Or

Main reasons for considering risk in capital budgeting decisions:

1. There is an opportunity cost involved while investing in a project for the level
of risk. Adjustment of risk is necessary to help make the decision as to whether
the returns out of the project are proportionate with the risks borne and
whether it is worth investing in the project over the other investment options
available.
2. Risk adjustment is required to know the real value of the Cash Inflows.

SANJAY SARAF SIR 451

 TABLE C
Normal probability distribution table
NUMBER OF STANDARD AREA TO THE LEFT OR NUMBER OF STANDARD AREA TO THE LEFT OR
DEVIATIONS FROM MEAN RIGHT (ONE TAIL) DEVIATIONS FROM MEAN RIGHT (ONE TAIL)
(Z) (Z)
0.00 0.5000 1.55 0.0606
0.05 0.4801 1.60 0.0548
0.10 0.4602 1.65 0.0495
0.15 0.4404 1.70 0.0446
0.20 0.4207 1.75 0.0401
0.25 0.4013 1.80 0.0359
0.30 0.3821 1.85 0.0322
0.35 0.3632 1.90 0.0287
0.40 0.3446 1.95 0.0256
0.45 0.3264 2.00 0.0228
0.50 0.3085 2.05 0.0202
0.55 0.2912 2.10 0.0179
0.60 0.2743 2.15 0.0158
0.65 0.2578 2.20 0.0139
0.70 0.2420 2.25 0.0122
0.75 0.2264 2.30 0.0107
0.80 0.2119 2.35 0.0094
0.85 0.1977 2.40 0.0082
0.90 0.1841 2.45 0.0071
0.85 0.1711 2.50 0.0062
1.00 0.1557 2.55 0.0054
1.05 0.1469 2.60 0.0047
1.10 0.1357 2.65 0.0040
1.15 0.1251 2.70 0.0035
1.20 0.1151 2.75 0.0030
1.25 0.1056 2.80 0.0026
1.30 0.0986 2.85 0.0022
1.35 0.0885 2.90 0.0019
1.40 0.0808 2.95 0.0016
1.45 0.0735 3.00 0.0013
1.50 0.0668
 Student’s T-Distribution
Level of Significance for One-Tailed Test
df 0.100 0.050 0.025 0.01 0.005 0.0005
Level of Significance for Two-Tailed Test
df 0.20 0.10 0.05 0.02 0.01 0.001
1 3.078 6.314 12.706 31.821 63.657 636.619
2 1.886 2.920 4.303 6.965 9.925 31.599
3 1.638 2.353 3.182 4.541 5.841 12.294
4 1.533 2.132 2.776 3.747 4.604 8.610
5 1.476 2.015 2.571 3.365 4.032 6.869

6 1.440 1.943 2.447 3.143 3.707 5.959

7 1.415 1.895 2.365 2.998 3.499 5.408
8 1.397 1.860 2.306 2.896 3.355 5.041
9 1.383 1.833 2.262 2.821 3.250 4.781
10 1.372 1.812 2.228 2.764 3.169 4.587

11 1.363 1.796 2.201 2.718 3.106 4.437

12 1.356 1.782 2.179 2.681 3.055 4.318
13 1.350 1.771 2.160 2.650 3.012 4.221
14 1.345 1.761 2.145 2.624 2.977 4.140
15 1.341 1.753 2.131 2.602 2.947 4.073

16 1.337 1.746 2.120 2.583 2.921 4.015

17 1.333 1.740 2.110 2.567 2.898 3.965
18 1.330 1.734 2.101 2.552 2.878 3.922
19 1.328 1.729 2.093 2.539 2.861 3.883
20 1.325 1.725 2.086 2.528 2.845 3.850

21 1.323 1.721 2.080 2.518 2.831 3.819

22 1.321 1.717 2.074 2.508 2.819 3.792
23 1.319 1.714 2.069 2.500 2.807 3.768
24 1.318 1.711 2.064 2.492 2.797 3.745
25 1.316 1.708 2.060 2.485 2.787 3.725

26 1.315 1.706 2.056 2.479 2.779 3.707

27 1.314 1.703 2.052 2.473 2.771 3.690
28 1.313 1.701 2.048 2.467 2.763 3.674
29 1.311 1.699 2.045 2.462 2.756 3.659
30 1.310 1.697 2.042 2.457 2.750 3.646

40 1.303 1.684 2.021 2.423 2.704 3.551

60 1.296 1.671 2.000 2.390 2.660 3.460
120 1.289 1.658 1.980 2.358 2.617 3.373
00 1.282 1.645 1.960 2.326 2.576 3.291
Notes